Frederik Ducrozet is a market economist for the investment banking division of Crédit Agricole SA. Responsible for monitoring macroeconomic developments in the eurozone and the ECB’s monetary policy, Frederik Ducrozet talks to BS Initiative about the latest monetary policies and institutional reforms implemented by the ECB and the eurozone to overcome the current crisis.
The ECB will now act as supervisor of banks in the eurozone; the risk of conflict of interest cannot be ruled out. How do you assess this risk for an institution such as the ECB and its potential economic and financial impacts?
FD – Conflict of interest is one of the risks identified by the ECB itself prior to the transition to the Single Supervisory Mechanism (SSM), but there are (many) others: coordination with national regulators, recapitalization of the most fragile institutions after the ECB’s upcoming review of bank balance sheets, managing the transition to a harmonized bank resolution regime, difficulties related to the heterogeneity of national practices, etc. The risk of conflicts of interest is probably the least problematic to manage, at least in the short term, as the other challenges seem difficult to tackle simultaneously in the coming months and years.
In practice, the ECB and the competent authorities have already announced the implementation of safeguards to ensure the strict separation of banking supervision and monetary policy functions, in order to minimize any risk of conflict of interest in the future. In particular, SSM decisions will be taken by a Supervisory Board whose composition (including representatives of the ECB and Member States, including those outside the euro area but participating in the SSM) and procedures (independence from the Governing Council but principle of subordination, with the latter retaining a right of veto) are in line with this principle of separation. It is always possible to imagine that this separation could be reinforced, if necessary, in the event of a dispute in the years to come. The SSM does not seem to me to be set in stone.
The ECB recently lowered its key interest rate. We are now very close to the 0% floor; in the event of another major shock requiring ECB intervention, what tools will the ECB have at its disposal to respond?
FD – In addition to lowering its main key interest rate in May, the ECB has been engaged for several months now in a form of communication easing that can be described as very » dovish » or « ultra-accommodative. » This involves fairly traditional signals of a possible further rate cut (including the deposit facility rate, which could theoretically move into negative territory) but also, more unusually, decisions on liquidity conditions in the Eurosystem. Thus, in February, Mario Draghi indicated that the ECB expected excess liquidity in the interbank market to remain above €200 billion despite banks repaying their three-year loans from the ECB (LTRO). In May, the ECB formally extended the procedures for refinancing banks via fixed-rate tenders and unlimited quantities until mid-2014, i.e., for a longer period than before. These decisions had the same goal: to make it clear to the markets that monetary and financial conditions in the eurozone would remain exceptionally flexible for a very long time.
It was therefore in a spirit of continuity that, on July 4, the ECB took a new step by explicitly committing to forward guidance, as the US Federal Reservehad done before it and, most likely, the Bank of England will do very soon. The ECB’s objective is explicit – to « introduce a downward bias on rates » and attempt to « decouple » eurozone rates from US rates as much as possible – through this new key phrase: « The Governing Council expects the key ECB interest rates to remain at their present or lower levels for an extended period of time. «
The symbolic nature of this announcement should not be underestimated. It represents a major break with the ECB’s historical position of « never committing in advance. » Nevertheless, there are currently two competing theories regarding the ECB’s strategy. On the one hand, there are those who believe that the ECB’s forward guidance is not a real change in strategy, but rather a communication « stunt » aimed at buying time, in the hope that the recovery in the United States will be confirmed and that rates in the eurozone will not rise too quickly. One element supporting this view is the very definition of « extended period, » which, according to several ECB members, is not fixed and will ultimately depend on the data, as with any monetary policy decision. On the other hand, there are those who interpret the ECB’s communication as a new step towards a more flexible and potentially more accommodative monetary policy, rather than an end in itself. I would tend to favor the latter interpretation. This change gives the ECB new room for maneuver that could still surprise us in the future. In particular, and as a first step, other initiatives are still possible, including a rate cut or a new very long-term tender specifically aimed at supporting SMEs. If necessary, the ECB could always go further in its current strategy by modifying its communication again without committing to quantitative targets, for example by adopting conditional guidance on rates (based on different scenarios for inflation, inflation expectations, growth, unemployment, credit, etc.) or, more likely, liquidity conditions. Finally, in the worst-case scenario of deflation, no measures would be ruled out, including large-scale purchases of public or private debt securities.
In your opinion, would it be a good idea for the ECB to grant the ESM a banking license in order to truly reassure the markets, particularly with regard to Spain and Italy?
FD – In my opinion, it is possible, within the framework of the existing treaties, that a banking license could eventually be granted to the ESM. But this is highly unlikely in the short term, even after the general elections in Germany in September. The main reason why Germany and certain other northern member states are still opposed to this is well known: a banking license would allow the ESM to refinance itself with the ECB for potentially unlimited amounts (in practice, limited by the collateral available to the ESM) and thus finance bailouts of sovereign states or their banking systems. For some, this procedure would be tantamount to disguised financing of public deficits and, above all, would entail a higher moral hazard risk than the current mechanisms, which are limited in size and subject to strict conditionality. The risk of moral hazard may be considered virtual or real, but it is essential to understand that it is central to the considerations of the mosthawkish members of the European Council and the ECB. Personally, I continue to believe that this is one desirable option among others . It could end up being adopted in a form that is more or less similar to the initial proposal. This could happen through a new acute crisis, as in 2011 or 2012, or, on the contrary, at the end of the institutional integration process, in order to offer guarantees of fiscal orthodoxy to those who oppose this measure.
At present, the mere existence of the OMT seems to be a sufficient firewall, but do you think it could ever be used, and under what conditions?
FD – The ESM is an (imperfect) substitute for the mutualization of sovereign debt in the eurozone, which could one day be achieved through the issuance of common debt securities (Eurobonds). The OMT is a lender of last resort for sovereigns that does not say its name, and which has a number of restrictions: activation conditional on a request for assistance from the ESM, unlimited amounts but interventions restricted to securities with residual maturities of between 3 and 5 years on the secondary market, etc. It is essential to bear in mind that it was these restrictions that enabled the OMT program to be accepted, or tolerated, by the hawkish members of the ECB, with the exception of the Bundesbank. It is the genius of Draghi, and with him Asmussen and Coeuré in particular, to have succeeded in imposing this concept by securing the support of Chancellor Merkel in the summer of 2012. In my view, the combination of OMT and banking union is the best, or least politically unacceptable, option within the current institutional framework, i.e., without amending the Treaties and without risking a major political crisis. This does not mean that these mechanisms should not be improved and that integration efforts should not be continued in the future—quite the contrary.
In the short term, the major success of the OMT is that it has eliminated the extreme risks of the eurozone breaking up, thereby significantly reducing the risk of financial contagion. However, there is no guarantee that this will be enough , and I still believe it is likely that the OMT will eventually be activated in some countries, for various reasons. Fundamentally, the effectiveness of a program that remains virtual (in the sense that the ECB has not yet intervened in practice) could diminish over time, especially if a new crisis erupts in a country with systemic repercussions in the eurozone. The market could « test » the ECB’s willingness (and cohesion) and its commitment to save the eurozone » whatever it takes. » Activating the OMT for certain countries under the program, including Portugal, would be particularly justified, especially since these countries already meet the conditions in terms of fiscal consolidation or strengthening their banking systems, and a specific facility specific facility has been created at the ESM level, which aims precisely to support them in their return to the market. The current ambiguity stems from another condition for activating the OMT that the ECB itself has imposed, which requires « regular and diversified » access to the markets. In a way, the ECB is asking these countries to have access to the markets before helping them to access the markets… It is not unthinkable that the ECB will show greater flexibility in the future, but at this stage this constraint still applies and could well be tested. Ireland is ahead of the game, with a few successful issues this year, but Portugal (and a fortiori Greece) do not meet this condition as it currently stands.
Ultimately, it is also conceivable that the OMT could be activated for Spain, or even Italy, but according to a different logic, as a preventive measure. Two types of scenarios come to mind: one in which Spain is forced to request assistance following a political crisis and/or a sharp and sustained rise in financing costs; the second in which the request for assistance is made at the end of a coordinated process and with the aim of « rewarding » several years of reforms, debt reduction, and painful structural adjustments, which would mean that the conditionality of ESM/ECB assistance would only relate to program monitoring, and not to new austerity or structural measures. Unfortunately, the history of the European crisis to date leaves little hope for our leaders’ ability to act « proactively. »
Mario Draghi told the National Assembly that « exchange rates are important for price stability and growth » and that, as a result, « the ECB is closely monitoring the consequences of the volatile movements observed in the markets in recent weeks. » Could this translate into concrete action by the ECB on the euro exchange rate?
FD – The question of the exchange rate in the ECB’s reaction function is one of the easiest to decide at first glance. The level of the currency does not directly influence the ECB’s decisions, only indirectly via its impact on inflation and growth, or via the destabilizing impact of excessive exchange rate volatility on macro-financial stability – this second argument was used extensively by Jean-Claude Trichet in his time. In practice, except in extreme cases that might justify direct intervention in the foreign exchange market, the ECB has always confined itself to verbal interventions, expressing concern, for example, about « excessive volatility » in the foreign exchange market. In the short term, the exchange rate must be understood as an essential component of monetary and financial conditions in the euro area, which the ECB should therefore monitor closely in order to avoid any passive, unwanted tightening of its monetary policy (it is generally estimated that a 10% appreciation of the euro against a basket of currencies has an impact comparable to a 100 basis point increase in the ECB’s key interest rate). If the euro were to appreciate more sharply, for reasons either exogenous or endogenous to the euro area, the ECB could respond by incorporating this exchange rate factor into its reaction function and highlighting the downside risks to inflation in particular (the ECB still considers the balance of risks to price stability in the medium term to be balanced). In my view, this is one of the main reasons why the ECB continues to raise the possibility of negative rates, even if such a measure remains unlikely at this stage. Indeed, the mere mention of negative rates has so far limited any rise in the euro, with the ECB probably hoping that the dollar will eventually appreciate more strongly. Let’s hope it’s right.
Interview conducted on July 15, 2013.
