ECB Vigilant as Rate Hikes Expose Financial Stability Weak Spots
31 May 2023
By Xavier D’Arcy – FRANKFURT (Econostream) – Recent rate hikes could reveal pockets of financial instability in the Eurozone, the European Central Bank said on Wednesday.
In its latest Financial Stability Review, the ECB said that tighter financial conditions, mainly due to central bank rate hikes, would ‘test [the] resilience of households, firms, governments and property markets’ in the euro area. The financial stability outlook was currently ‘fragile’, the report concluded.
Vice President Luis de Guindos, in his foreword to the report, said that ‘as we tighten monetary policy to reduce high inflation, this can reveal vulnerabilities in the financial system. It is critical that we monitor such vulnerabilities’.
In a briefing with journalists on the release of the report, he said ‘price stability is a precondition for financial stability. Without price stability, it's very difficult to have a stable financial system in place.’ He defended the ECB’s rate hikes, despite their effects on the financial system, saying that ‘there are other factors that are compensating this normalisation of monetary policy.’
‘Our primary objective is price stability, we take into consideration all the elements and financial stability considerations’ he said.
Eurozone real estate markets were ‘undergoing a correction’, the ECB said. The recent fall in house prices had reduced ‘overvaluation’, but ‘could turn disorderly if higher mortgage rates increasingly reduced demand’, according to the report. Furthermore, commercial real estate markets remained in a downturn and investment funds in the sector remained vulnerable.
Governments also faced increased pressures in the new high-interest rate environment, the ECB said. Although sovereign debt service risks were being ‘kept in check by benign debt service conditions’, debt service ratios in some euro area countries remained high and rollover risks had increased as interest rate uncertainty had ‘added to high price volatility in sovereign bond markets’, the report said. A further tightening of financial conditions ‘could spark an increase in borrowing costs for more-indebted sovereigns’ and ‘funding conditions could become more challenging, particularly when sovereigns need to issue high volumes of debt in volatile and shallow government bond markets’, the ECB said.
‘Higher-than-expected deficits combined with lower growth are limiting fiscal space and may put debt dynamics on a less favourable path, especially in countries with high debt levels’, de Guindos said. ‘In addition, as government bond yields have increased sharply across the euro area, higher funding costs will ultimately weigh on sovereigns, in particular, those with high short-term debt servicing needs.’
Overly exuberant investors were another potential risk, according to the report, with inflated equity market valuations maybe being ‘based on overly optimistic expectations for the economy’. The currently compressed equity risk premium raised ‘concerns over the potential for disorderly corrections in the event of a major economic downturn’, the ECB said. Furthermore, quantitative tightening by major central banks around the world could support higher risk-free rates and make de-risking more attractive for investors, leading to a ‘crowding out of riskier assets’ and a ‘less orderly correction in equity and high-yield corporate bond markets.’
Eurozone banks ‘proved resilient’ to recent stress in the US and Switzerland ‘on account of their limited exposures’, the ECB said. This resilience was ‘supported by strong capital and liquidity positions resulting from regulators’ and supervisors’ efforts over recent years.’ It was ‘essential to preserve this resilience amid some concerns about banks’ ability to build up capital’, the ECB said.
‘Funding liquidity for euro area banks has been showing signs of deterioration consistent with cyclical factors such as greater redemption and marginal risk’, de Guindos said. ‘Redemption risk has increased due to low deposit remuneration compared with money market rates, while haircut marginal risk also increased due to higher volatility in government bond markets.’