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Media Call with Benn Steil on European Central Bank Meeting

Speaker: Benn Steil, Senior Fellow and Director of International Economics
Presider: Neil Irwin, Senior Economics Correspondent, The New York Times
April 2, 2014
Council on Foreign Relations

OPERATOR: Excuse me, everyone. We now have all speakers in conference. Please be aware that each of your lines is a listen-only mode. At the conclusion of today's presentation, we will open the floor for questions. At that time, instructions will be given as the procedure to follow if you would like to ask a question. I would now like to turn the conference call over to Neil Irwin. Mr. Irwin, please begin.

IRWIN: Thanks so much. Welcome everybody. I'm Neil Irwin. I'm an economic correspondent at The New York Times and author of The Alchemists, a book about global central banks. We're here to talk about the ECB and its meeting this week. And more broadly, the challenges facing the Eurozone and what happens next.

We're here, of course, with the Director of International Economics at the Council and Foreign Relations, Benn Steil. Also the author of The Battle of Bretton Woods, an excellent book about the conference that started it all in Bretton Woods, New Hampshire in 1944.

I will start with 20 minutes of me and Benn speaking. And we'll go to your questions after that. Benn, we just got this - yet another number showing very low inflation in the Eurozone - a half a percent over the last year. The year ended in March.

You know, it very much seems like they're, you know, one negative shock away from a deflationary kind of situation. A lot of calls, including from members of the Governing Council of the ECB to find new ways to ease. I'll start with the most basic question. What do you expect the ECB to do on Thursday? And what do you think they should do on Thursday?

STEIL: ECB doesn't have much room to move downward further in terms of its policy rate, which is already down to 0.25 percent. They could launch some form of QE. That is to engage in asset purchases. Those are still somewhat controversial within the governing council. Speculation right now is focused on the possibility of the ECB pushing its deposit rate down below zero.

In other words, banks would actually be charged for parking reserves at the ECB. The idea behind that is that the banks would thereby be stimulated to lend out those funds, rather than parking it at the ECB.

IRWIN: And is that a good idea?

STEIL: Excuse me?

IRWIN: Is that a good idea, do you think?

STEIL: Oh, it is highly unlikely in my view to stimulate the private sector lending that the ECB says that it wants. The banking sector is an enormously important transmission mechanism for monetary policy in the Eurozone-much more than it is in the United States. Banks account for about 80 percent of commercial credit in the Eurozone as compared to only 20 percent in the United States.

So what the most likely affect in my view of the ECB pushing the deposit rate down below zero, is that Eurozone banks will continue to gobble up Eurozone sovereign debt at a veracious rate. This is what they've been doing for the past several years. And the ECB has actually made it a priority to break the link between the banks and the sovereigns.

Because each is dragging down the others. The banks load up on sovereign debt which declines in value as the markets come to fear that the sovereigns will be called upon to bail out the banks. So each is dragging down the other right now. And the ECB is anxious to break that bond.

IRWIN: I mean a lot of it seems to be animating the urgency among some members of the ECB Governing Council is this rise in the Euro on currency markets. Are they looking at the right thing? How much is a rising Euro a threat to their domestic economy and to financial stability?

STEIL: I think there's no doubt that a rising Euro doesn't help. And you're seeing members of the governing council like the Germans, in particular. Jens Weidmann at the Bundesbank apparently trying to talk down the Euro somewhat. But unless we get particularly aggressive action on the rate or asset purchase front on Thursday, I don't think you're going to see the Euro decline significantly.

IRWIN: So you mentioned QE and the ECB while they've done some - they did some bond buying during the darkest days of the Eurozone crisis to try and stabilize things. They've generally not used their balance sheet to buy sovereign debt -- the way the Bank of England has, the Bank of Japan, the Federal Reserve.

If we were to see asset purchases, what might that look like? I mean there's this really allergy to buying sovereign debt for...

(CROSSTALK)

STEIL: ... Yes.

IRWIN: The charter. What will look like if EC joins the QE party?

STEIL: As you mentioned, it is very controversial within the Eurozone. The perspective is from certain quarters that it does involve monetizing national debt within the Eurozone. So they would have to find mechanisms to negate that argument.

I mean one way to do it, if the ECB isn't going to buy sovereign debt, is to buy it in proportion to the equity capital that each national central bank represents within the Euro system. So that there's no indication that any particular sovereign is being favored.

IRWIN: What about private assets? Does it seem like an option to buy...?

(CROSSTALK)

STEIL: ... Yes.

IRWIN: (Inaudible) bonds? Things - that sort of thing?

STEIL: I think it's an option. I don't expect tomorrow. It - if the ECB Governing Council comes to the conclusion that the banking sector right now simply is not in sufficiently good condition to boost private lending, that would be the obvious next step.

But that won't be on current controversial either. When the central banks get involved in questions of sector or credit allocation, naturally that raises all sorts of political questions about whether the central bank is operating in a properly politically neutral manner.

IRWIN: Yes, it's easier to say buy private assets, but then you have to decide which private assets which ...

(CROSSTALK)

STEIL: ... Yes, precisely. In the United States, of course, the central bank has focused on the mortgage market. I mean there are good reasons for that when a mortgage debt market in the United States is large and very liquid. But, of course, that's not been uncontroversial.

I am -- part of the problem that the Fed will face when it eventually looks to start tightening policy is what to do with this massive stock of $1.5 trillion worth of mortgage back securities that is built up.

Former Chairman Ben Bernanke had suggested that the Fed would not, in fact, sell these securities, would hold it until maturity. So it would have to find other means -- nontraditional means of tightening policy.

IRWIN: Let's turn to banking. You had an interesting Op-ed in Wall Street Journal on Europe's banking problems. How far along are they in dealing with the root of their problems in the banking sector? And what needs to happen to really have a healthy European banking system?

STEIL: They're not nearly far along enough. There's a huge legacy of unacknowledged bad debts in the Eurozone banking system. The ECB is determined to get it - to grips with this this year through their ongoing bank stress tests. They're doing stress tests along the 2009 U.S. model of the largest 128 banks.

As I lay out in the bad, however, I don't think these stress tests are going to be creditable in the market given the structure that the Eurozone has in place right now to recapitalize banks that may fail these tests.

IRWIN: What would a stronger regime look like?

STEIL: Right. Right now banks that fail the tests will be instructed to go out and raise capital. And there's a hierarchy of three ways they can do so that the ECB has laid out. First, is to raise capital on the private markets. Eurozone banks have been very, very reluctant to-date to raise private capital. And the reason is that many Eurozone bank stocks are trading at less than book value.

Which means that investors believe that the banks are overstating the value of their assets. And that makes private capital very expensive. If the banks that fail their test are unable to raise sufficient capital to plug the hole privately, then they are supposed to turn to their national governments.

Now in many cases national governments in Europe are already significantly over-indebted. So there are clearly limits there. The third step is to turn to the so-called ESM. Now the ESM is authorized to provide funds for bank recapitalization, but not directly to the banks. They actually will make loans to the sovereign and the sovereign will use those loans to recapitalize the banks.

And they think you can immediately see the problem with that. If the sovereigns are already considered to be over-indebted in the markets, then borrowing money in order to recapitalize the banks is clearly not a creditable mechanism to -- to -- to do so. So what was different about the U.S. stress test back in 2009?

Well when they were launched, funds to recapitalize the banks directly was already available through the so-called Capital Assistance Program. So the markets knew that banks that failed their stress tests, ultimately had a creditable backstop from the United States government. And this actually meant that private investors were ready to step forward and provide that capital just knowing that that backstop was available.

I should emphasize that no cap funds were actually used to recapitalize the banks. Just the availability of those funds were sufficient to draw forth interest from the private sector. That's what we need from Europe. The barrier right now is that German law implementing the ESM explicitly prohibits direct recapitalization of Eurozone banks.

IRWIN: I wonder if the common thread here is that there's sense of complacency that set in since the most acute phase of the Eurozone crisis has passed. From now without (ph) about to implode, you know, we've had a couple of quarters of growth in Spain, some of the peripheral countries - Greece is coming back to the bond markets. You know, how much of this is a problem of will and complacency as opposed to a, you know, a troubling economic situation?

STEIL: I think there is a degree of worrying of policy inertia. The problem that I identify in the op-ed you mentioned and the policy innovation memorandum that lays out these ideas in greater detail is that the Eurozone banking sector is deeply, deeply impaired. And Europe is way behind in terms of rectifying that problem. And as I explain in the op-ed, the ECB stress tests are really a very significant last chance to get to grips with this. Europe has many failed bank stress tests in the past. Back in 2011, for example, the European Banking Authority conducted what was promoted as a very stringent test of Eurozone bank health.

And you may remember that Dexia, the large Franco-Belgian lender passed these tests with flying colors only to require a government bailout just a few months later.

In 2012, Spain had conducted a much heralded test with very similar conspicuous flaws among which were ignoring large bank exposures to risky foreign assets such as Portuguese debt. It also assumed a so-called adverse scenario in which unemployment was no worse than it was when the test was conducted, which clearly wasn't creditable. Unemployment, in fact, is slightly higher now than it was at the time that the test was conducted.

So these tests really have not been credible. And as I argue in the op-ed, the ECB's test won't be creditable unless there is that backstop through the ESM for direct bank recapitalization. If it's not there, the markets, A, won't trust the ECB's verdicts when it says that a given bank has passed because the markets will fear that the ECB simply doesn't want to declare that a bank is under-capitalized.

And, of course, if the ECB does fail specific banks, the market is going to be very worried that these banks are not going to be able to attract sufficient capital and may, in fact, be forced to renege on their debts. It could cause what's in effect a run on these banks in the wholesale market. Short-term lending to them could dry up.

IRWIN: How do read the internal politics of the ECB right now on these questions? We've heard some concern about -- about initial (ph) more easing (ph) from even the hawkish wing of the bank you mentioned, right?...

(CROSSTALK)

STEIL: ... Yes.

IRWIN: And interesting (ph) president, the finished central banker - how do you think Mario Draghi is trying to finesse this naughty set of tasks and guidance committee towards it decision?

STEIL: I think Mario Draghi would definitely like to take a more dramatic action and he'd like to take it in short order. But he has to move along his colleagues who are moving in his direction, as you said. The Germans do appear to be more willing to countenance further monetary stimulus. But he can't jump too far out in front of them. Because he'll lose credibility if he can't deliver what he seems to be promising to the markets.

IRWIN: Seems like for years we've been talking about this adjustment - this internal adjustment that - happened between the core Northern European economies and the peripheral - with, you know, labor costs. And, you know, it's happening in a very slow grinding way of - in terms of valuation. How much progress do you think has been made? And how close are we to a really resilient Eurozone economy that begin growing again? Or...

(CROSSTALK)

STEIL: ... We -- we -- we

IRWIN: (Inaudible) along the way.

STEIL: Yes, we've made some very modest progress. In other words, we are seeing some pickups in competitiveness in Spain, improvement in current account deficit, labor costs. But the problem really is this. And this is why, I think, we're far from out of the woods. If you're going to have what's in essence zero percent - or very close to zero percent inflation around the Eurozone as a whole, that actually implies the need for massive deflation in terms of labor costs in the periphery countries, in particular Spain, Portugal, Italy, and Greece.

And it's not clear yet the extent to which the political will and ability to push that through. As you know, there's a lot of optimism right now that Greece could return to bond markets later this year.
Greece is supposed to have a primary budget surplus this year. But if you look beneath the surface - look at the political situation in Greece, you see that the ruling a new democracy party is only just barely ahead of far left-wing Syriza party in the polls.

So it's not clear, right now, that the populous is willing to endure the amount of pain they will need to to make these adjustments without higher inflation in the Eurozone.

IRWIN: And with that I think we'll turn to your questions. We'll now get instructions on how to do that.

OPERATOR: Thank you. At this time, we will open the floor for questions. If you would like to ask a question, please press the star key followed by the one key on your touchtone phone now. Questions will be taken in the order in which they were received. If at any time you would like to remove yourself from the questioning queue, please press star two. Again, to ask a question that was star one. Our first question comes from Michelle Carusso (ph), with CNBC. Ms. Carusso (ph), you may go ahead.

QUESTION: My phone wasn't working. Considering the big drop in yields that we've seen in a lot of the Eurozone, is the market expecting big action tomorrow from Draghi (ph)? And is it going to be disappointed?

STEIL: I don't think they're expecting a big action. I think there's a consensus that moving the deposit rate down is the next likely shift we're going to see from the ECB. But I do think that the market is encouraged that the debate within the governing council is clearly shifting in the direction of the doves. Things may not be moving at the pace the market would like to see. But it is from their perspective moving in the right direction. I would emphasize, however, that a lot of these purchases we're seeing of Eurozone sovereign debt are actually coming from large Eurozone banks. And again, this is a problem that the ECB has been trying to get to grips with. So the fact that investors are loading up on Eurozone sovereign debt should not be universally welcome.

What we need to see is a significant growth in private sector credit. And we're not yet seeing any signs that that's forthcoming.

OPERATOR: Thank you. Again, ladies and gentlemen, if you would like to ask a question, please press star one now. We are currently holding for questions.

IRWIN: OK. Let's talk a little bit more about the options in front of them. You know a negative deposit rate - how much - what is the evidence? We have some charts -- tried in Denmark? Is that correct? What do we know about how that works in practice?

STEIL: Sweden? We don't know a lot. I mean they're - the signs we have from those smaller countries indicate that it can help at the margins. But I should emphasize again, Neil, that the degree to which it works depends very much, particularly in the Eurozone on the health of the banking sector.

Which is - I emphasize that it's much more important in the context of the Eurozone than it is in the United States. The banking sector is a vital transmission mechanism for monetary policy. And unless that mechanism is functioning, negative deposit rates won't really do very much to stimulate private sector credit.

As I've emphasized, I think at the margins it will stimulate banks to stock up on more Eurozone government debt. But I don't think that's the sort of thing that's going to revive confidence in the European banking sector. And remember that's exactly what the ECB is trying to do through this stress testing regime.

IRWIN: Questions coming in?

OPERATOR: Thank you. Our next question comes from Lisa Benstram (ph), with Citigroup.

QUESTION: Hi, thanks very much for this Benn and Neil. Question - could you comment a little bit on the demand for credit within the Eurozone - I mean we're sort of stuck in a similar situation here where there's ample ...

(CROSSTALK)

STEIL: ... That's right.

QUESTION: Low costs. But what are your views on demand for credit and?

STEIL: Yes I mean it's clearly subdued. Having said that, there really is significant anecdotal evidence that firms, for example, in Italy face much higher costs of credit than a comparable firms in terms of their financial conditions and prospects in Germany. So the fact that there's subdued demand for private sector credit does not explain why the price of credit in these countries is as high as it is.

And the disparity and the cost of private sector credit is a clear indication that the Eurozone's financial sector is still a very flawed structure. We are very far away from seeing a unified - a banking and financial sector in Europe.

QUESTION: Is there something thought that the ECB or, you know, that really can be expected to do to address that, even with rate cuts or provisions of other types of accommodation?

STEIL: Not with rate cuts. As you know, it's been a German priority to build a single banking regime in Europe. The European Central Bank will take over as the -- overarching supervisor later this year that will come in November. So we are moving in that direction. But this is not going to be on a time scale that's going to stimulate our private sector credit this year obviously. We need significant action now in the absence of a unified European banking sector.

QUESTION: Great. Thanks, Benn.

STEIL: My pleasure.

OPERATOR: Thank you. Ladies and gentlemen, if you would like to ask a question, please press star one now. There are currently no questions in the queue.

IRWIN: So, Benn, it seems like, you know, the difference between the European financial system and the U.S. financial system looms large here. We keep talking about the banking sector. Is this just a byproduct of capital markets that are more centered around bank lending rather than, for example, corporate debt issuance?...

(CROSSTALK)

STEIL: ... Absolutely.

IRWIN: (Inaudible) put money into the financial system through QE and that didn't find its ways into corporate lending. How much are these different context - something that looms right now?

STEIL: That's right. I mean we did see sort of a 'tale of two cities' in the United States, in terms of the - our economic recovery. In the early years after the crisis, small to medium-size enterprises that were dependent on bank lending in the United States really faced a significant real cost of capital.

Whereas, large companies like IBM that could issue debt directly into the markets were really able to feast on a very low-cost debt. So the fact that the corporate bond market is as developed as it is in the United States did have a significant effect in terms of promoting recovery but it was a very imbalanced recovery. Recovery in the small to medium-sized enterprise sector was very much delayed by the need for banks in the United States to work off the legacy of bad debt. And, of course, Europe is way behind in that regard.

OPERATOR: Thank you. Our next question comes from Lee Collum (ph) with North Texas Public Media.

QUESTION: Thank you and thank you, Benn. This has been a fascinating presentation. And I want to add parenthetically, I'm sorry to miss you Dallas. I think you're going to be there this week.

(UNKNOWN): Yes, I'll actually be there tonight. Thanks, Lee.

QUESTION: Well, I'm sorry to be travelling. I wish I was there as well. My question is this -- would you talk more about Italy where it seems to be, perhaps, the behead (ph) headache. But the one that could perhaps cause the most trouble.

STEIL: Yes, I mean Italy is far from out of the water. The fiscal situation seems to have stabilized somewhat. The political situation, as you know, has not. Italy is the same political mess it's always been and reforms are moving extremely slowly.

It's interesting that Italy is the home of the largest bond- trading system in Europe-the MTS system that became part of the London Stock Exchange Group after the London Stock Exchange took for the Borsa Italiana. But the reason why MTS became such a major player in the European bond markets, was because the Italian government was such a prodigious issuer of debt.

That is MTS was overwhelmingly focused on sovereign debt and not corporate debt. So corporate in Italy are still facing a much higher cost of capital than comparably sized corporate in the United States.

QUESTION: Thank you.

OPERATOR: Thank you. There's - I'm sorry go ahead.

IRWIN: Are there anymore?

OPERATOR: No, sir. There's no more questions in the queue.

IRWIN: OK, there's one kind of thing to wrap things up unless somebody chimes in with a question in the next little bit. You know, if you had told me - you mentioned the political tensions and the political difficulties in Greece where, you know, you've had 30 percent employment for year-after-year.

You know, if you'd told me four years ago that we'd be still be in this kind of economic situation --a lot the peripheral European counties, I think I would expect to see people in the streets, to see extremist parties getting a lot of traction.

You know, how much are we - how much are you convinced or how much can we be confident that this center household - that the Eurozone experiment is going to survive? That there is a political will to keep this unity even as there's a very difficult economic situation in a number of the peripheral countries. How much are we out of the woods on the political front?

STEIL: I think we're moving in the right direction. But I don't think we're moving fast enough. And I am less sanguine than the markets are. We talked about Greece earlier and the fact that the far left Syriza party is neck-in-neck in the polls with the ruling New Democracy party. And Syriza, as you know, is absolutely adamant that the bail-out deal that they've gotten from the EU and the IMF is unacceptable and they want it wholly renegotiated.

On the other extreme, you have the far right Golden Dawn party that the government is really struggling to control. This is an armed group that has infiltrated the police force in the country. So I think the markets are, perhaps, more sanguine than they should be right now given the political situation on the ground.

I would also emphasize that the fact that the improvement in Greed public finances-in particular, Greece achieving a primary budget surplus is not necessarily a net positive in terms of cooperation with its northern Eurozone creditors in terms of further reforms in the country. The fact that Greece has a primary budget surplus right now gives it a lot more negotiating leverage than it has had in the past.

In other words, Greece no longer needs the capital markets in order to fund its current operations. The only thing it needs to borrow money to do is to pay off the existing creditors. So this gives Greece quite a lot of leverage vis-a-vis its competitors. Because if they are not accommodating and Greece should choose to default on a debt, it doesn't actually need its creditors in order to keep the country going.

And you are seeing rising attentions in these negotiations and the Greek government being more assertive. I think you're going to continue to see that sort of thing over the next year. And I think German public opinion is going to be critical in terms of determining how this plays out over time.

IRWIN: Great, any other questions?

OPERATOR: Yes, sir. Our next question comes from Blatr Mersingnorelli (ph), with Bretton Woods Research.

QUESTION: Hi, Benn. I had a question with regard to the change in German law. I understand that Finance Administer, Schauble (ph), is saying or they're insisting on treaty change is sort of the path to direct bank recapitalization. You're suggesting German law needs to be changed? Which one is most likely to occur within the next 12 months?

STEIL: The various - the German coalition parties, the CDU, CSU and the social democratic party. They agreed back in the fall on a change to German law which would allow direct recapitalization of Eurozone banks through the ESM up to 60 billion Euros. But that law - the law to do that has not yet been implemented. Schauble (ph) has indicated that once that necessary change to German law is passed, he will be in a position to vote for reform of the ESM in order to allow it to engage in direct bank recapitalization. But as Diana Walker (ph) emphasize in our op-ed, it is critical that the ECB not release results of its stress test until the ESM has that capability. Otherwise, we believe that the results will not be creditable and will spook the markets far more than it will reassure them.

QUESTION: Thank you.

OPERATOR: Thank you. There are currently no more questions in the queue at this time.

IRWIN: Great. I think we'll end a little early. Benn, thanks so much for all of your thoughts. And it'll be - we'll all be watching with fascination on Thursday morning as Mario Draghi takes the stage. Thanks very much.

STEILL: Thank you, Neil.

OPERATOR: Thank you, ladies and gentlemen. This concludestoday's teleconference. You may now disconnect.

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