Address by Director Helena Adegas at the DZ BANK Capital Markets Conference: Risks to European Financial Markets and Inflation, with a focus on Portugal
It is a great pleasure for me to participate in this conference to discuss the challenges faced by the international capital markets.
This session is dedicated to the world view, which is a very wide topic, but I will narrow my focus and address the Risks to European Financial Markets and Inflation, with a focus on Portugal.
Let me share with you the perspective of a medium size central bank integrating a monetary union, as it is the case of Banco de Portugal.
After years of pandemic, followed by the outbreak of a war in European territory, we face a period of uncertainty and change, at several levels: geostrategic, political, economic, and technologic.
In the last year, we have witnessed the inversion of the economic cycle: after years of very low and even negative levels of inflation, as well as interest rates, and ultra-loose monetary policies in all advanced economies, 2022 has brought a steep change. Inflation levels increased sharply and reached two digits in some cases, and central banks around the world reversed the stance of their monetary policies. We have observed steep rises in interest rates and the beginning of the decline in central banks’ balance sheets. Quantitative easing, or QE, gave way to quantitative tightening, or QT.
In Europe, this movement started a bit later than on the other side of the Atlantic, but the evolution has been very fast. In less than a year, we have witnessed the start of the ECB’s official interest rate hikes, followed by the end of net asset purchases, the early repayment of the TLTRO loans by the European banks and, more recently, the beginning of QT in the sense that the Eurosystem no longer reinvests in full the maturing amounts of its asset purchase program.
The evolution of the Banco de Portugal’s balance sheet mirrors the one for the whole Eurosystem, in our own scale.
But the challenges that we face go well beyond inflation and the turn in the economic cycle. They relate to cyber risks, climate change and sustainability, digitalization and CBDC, and the transformation in the way we organize work.
Some risks might become more acute in the medium-term. In fact, there may be a tradeoff between the short-term priorities – tackling inflation, or overcoming the constraints and bottlenecks caused by the war – and medium-term risks – such as climate change and the need to put in place the transition to new energy systems. It is important to guarantee that the current immediate concerns do not delay the efforts to meet the sustainability goals.
Amid all this change, the role of central banks is to safeguard the confidence of the economic agents in the good functioning of the financial system. That means pursuing two goals and making them push in the same direction: price stability and financial stability. And that brings us to the most difficult task that central banks face in these challenging times: how to calibrate monetary policy to control inflation without causing a halt in economic growth or a turmoil in the financial system.
And in fact, concerns have been raised about some economic agents being unprepared for a steep rise in interest rates. It is a fact that banks – and even central banks – have a maturity mismatch in their balance sheets that exposes them to interest rate risk. Although bank profitability has improved in the past few years, a tightening of financial conditions may weigh on bank profitability in the future. And it is also true that some economies have a large share of bank credit at variable rates (mostly mortgages), making clients very vulnerable to steep interest rate rises.
So, is there a tradeoff between the goals of price stability and financial stability, particularly in the tightening part of the cycle? I would argue that this does not have to be the case. It only means that the calibration of monetary policy needs to be handled with care and should be complemented with a proactive macroprudential policy. Instead of tradeoff, we should stress the idea of complementarity.
In Portugal, a macroprudential recommendation was introduced in 2018, in a context of economic recovery, a long period of very low interest rates and a strong rebound in housing prices. This measure was adopted, on a comply or explain basis, as a preventive action, given the signs that financial institutions were easing their credit standards. Soft limits were set to the ratio of loan to value (LTV of 90%), debt service to income (DSTI of 50%) and to the maturities of the loans based on the age of the debtor, with the aim to converge gradually to 30 years average remaining maturity in mortgage loans. There is also a requirement of regular payments of capital and interest, to prevent an accumulation of debt. Banks have been reducing the percentage of variable rate loans, that are still dominant in Portugal.
These measures, meant to ensure that the banking sector remained resilient to adverse shocks and to protect the banking customers from overborrowing, have proved to be very effective in the current circumstances. At the end of 2022, the Portuguese banking sector had a ratio of non-performing loans (NPL) corresponding to 3% of total credit, which represents a reduction of more than 10 percentage points in five years. And the household debt ratio, as a percentage of disposable income, fell to levels below the average of the euro area.
In the last few months, in both sides of the Atlantic, we have seen some signs of vulnerability in segments of the financial system, that are reminiscent of previous crises. But there are important differences that may allow us to feel more reassured. Although we are facing a different source of risk – maturity mismatch – we notice that the banking sector is more robust; we are close to full employment; and private and public debtors are less leveraged than in the past.
The euro area has a particular characteristic that makes the ECB’s task rather more challenging. Being an uncomplete union of sovereign states with autonomous fiscal policies and no common deposit insurance, the euro area faces a risk of fragmentation, particularly in times of tightening. For that reason, the creation of the Transmission Protection Instrument (TPI) was an essential step to prepare the ground for the change in monetary policy stance. The simple announcement of the TPI (like the OMT, a decade ago), seems to have been enough to reassure the markets that the beginning of the tightening cycle (interest rate rises and QT) would not create any problems for the European sovereign funding costs. This was visible in the evolution of the sovereign spreads towards Germany.
In this context, you may ask, what are the main priorities and concerns of a central bank in the position of Banco de Portugal? Let me give you my personal view.
First and foremost, the Banco de Portugal is committed to participate closely and actively in all the analysis, discussion and decision taking that is going on at the Eurosystem level. When we mention it, the first thing that comes to our minds is monetary policy decisions. But it goes much further than that, to all areas of cooperation between central banks.
Second, it is important to take an active part in the regulatory developments in the financial system, in all dimensions: macro and micro prudential, conduct, resolution and, most of all, in the architecture of the banking union.
Third, it is necessary to evaluate the implications of the creation of a digital euro, if that decision is taken, and to fully participate in its design and implementation.
Forth, it is crucial to raise awareness on the implications of climate change and energy transition, both at the level of monetary policy and financial stability, as well as at the level of central banks’ portfolio management and internal operations. In this context, I should stress the importance of the concerted disclosure, by all euro area central banks, of their carbon footprints. This is a major step, for the catalyst role played by central banks, giving the example to the market participants and pushing towards better standards and practices.
And finally, it is essential to promote economic and financial literacy, to enable a better understanding of the central bank mandate, and its decisions, and to lead to more knowledge-based decision-making by the individuals regarding the use and management of money. A special focus should be directed to the digital channels, to prevent the risk of exclusion of the most fragile segments of the population.
Let me conclude.
We face a period of uncertainty and change.
The major immediate challenge for central banks is to tackle inflation, without causing a halt in economic growth or a turmoil in the financial system.
But the challenges that we face are wider and more varied. We should not lose sight of medium-term risks – such as climate change – or goals like the full completion of the banking union.