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Managing Director of Arbat Capital, believes that the European economy, which has already faced challenges such as the energy crisis, influx of refugees, and rising military expenses, will be unable to withstand the fading credit impulse. According to him, Europe is currently encountering difficulties in adapting its economy to significantly higher interest rates, and this will not only cause a recession but also raise the risk of a financial crisis. In his opinion, the fading credit impulse will become the decisive factor that breaks the camel’s back for the European economy.
Europe successfully weathered the energy crisis during the spring-summer of 2022 without incurring major losses. It is no longer critical whether the warm and relatively late winter, Norwegian gas, American LNG, or measures to reduce gas consumption helped. Although analysts initially predicted a recession in the fourth quarter of 2022, it did not occur. Furthermore, many analysts have revised their GDP growth forecasts for 2023 from a potential recession to a small growth of 0.4% based on the Bloomberg consensus forecast. However, technical recession predictions for the economy of Western Europe during the first and second quarters still remain valid, except for the “Eastern flank” of the EU, which includes the UK and Norway.
Straw for a Camel
Global central banks, including the ECB, the Bank of England, and the regulators of the Scandinavian countries, have tightened monetary policy (MP) to an extraordinary degree due to the unprecedented acceleration of inflation caused by a “perfect storm” of factors. These factors include the excess amount of printed and unbacked euros, pounds, and other currencies of developed countries during the 2020-2021 pandemic, a significant increase in demand following the lifting of COVID restrictions at the end of 2021 and the beginning of 2022, and the energy and food crisis after the commencement of the Russian “special operation” in Ukraine. However, there is a more significant negative factor for Europe that leads to an almost inevitable recession, and its impact on the economy becomes evident with a considerable lag.
Despite the fall in commodity prices, including an 85% decrease in European gas prices from last summer’s peak, inflation has proven to be more resilient than what global CB leaders had anticipated in 2021. A robust labor market has triggered an inflationary spiral of wage growth, which continues to unwind. Consequently, core inflation (excluding food and energy prices) in the EU soared to a new historical high in February 2023, reaching 5.6% year on year, compared to the typical 1% observed in the past decade.
The global cycle of tightening MP has become the fastest since the last inflationary crisis of the late 1970s and early 1980s, and it is still ongoing. For developed economies that have been accustomed to zero rates and ultra-stimulative policies over the past 15 years, a sharp increase in borrowing costs will be a significant factor in the upcoming recession. However, for central banks, a recession is desirable since it is necessary to break the spiral of wage growth.
The shock caused by the tightening of MP is expected to be particularly strong in the Eurozone. This is because the ECB rate has been negative since 2014, and the level of government debt is significantly higher than that of the US. Additionally, there is a stronger effect of rising commodity prices in Europe, while the US has strengthened its position as a leading exporter of energy and food in 2022. The strength of European trade unions and the less flexible local economy also make it easier to unwind the wage spiral. Moreover, the ECB can learn from the Fed’s mistake of prematurely slowing down the pace of rate hikes in January 2023. Therefore, it is quite likely that the ECB will take at least two more significant steps, bringing the rate level to 3.5-3.75% in the summer.
The European economy, which has already faced challenges such as the energy crisis, influx of refugees, and rising military spending, is expected to be heavily impacted by the tightening of MP, with the dwindling credit impulse acting as the final straw. Therefore, it is crucial to closely examine the state of the banking sector and credit activity in the region.
On the risk curve
European banks are experiencing record profits and soaring shares (as per the Euro STOXX Banks index), having finally shaken off the negative burden of negative rates. Despite the ECB’s rate hike, the impact on interest rates in the banking sector, particularly on deposits and current accounts, has been minimal. Banks are not rushing to offer their customers higher rates, instead, they are actively profiting from increased loan profitability, especially on fallen bonds which have reacted significantly to the ECB’s actions.
The European Banking Authority (EBA) reports that banks face rising costs due to wage and bonus increases. In 2021, the number of employees earning more than €1 million increased by 42%, reaching almost 2,000 people. While banks can still address this problem through layoffs, an even more serious threat to them is the expected increase in overdue loans issued during the era of negative rates. The banks have been forced to move further along the risk curve towards less quality borrowers and complex structured products due to a decade of ultra-cheap money. This move towards riskier products can result in significant losses in an unfavorable situation.
The situation where even the largest bank can face financial difficulties in a relatively favorable situation was demonstrated by Credit Suisse. If the situation worsens, the risks for banks will increase significantly.
As banks will have to raise rates on deposits and loans, the ECB’s monetary policy transmission mechanism will become more effective. A higher rate will lead to a decrease in economic activity and an increase in unemployment, which, according to regulators’ calculations, will help reduce inflation to the target level of 2%. Achieving this without the economy going into a recession means finding a balance between inflation and employment that modern economics has never achieved before! The remarkable strength of the labor market is working in their favor, as it continues to recover rapidly after the pandemic, resulting in unemployment levels in the four main eurozone countries being at their lowest levels since 1981.
The effect of rising rates on the real estate market in Europe has just begun. Sweden is a good example, where the Riksbank raised its rates a quarter earlier than the ECB and resulted in a significant increase in mortgage rates from 1.75% to 4.1% in 2021-2022. This led to a drop in construction volumes by 55-60% and a subsequent 17% fall in real estate prices. The situation is slightly better in eurozone countries due to the less securitized mortgage market. However, the effect of the ECB’s rate increase will still result in falling prices, albeit with a lag of two to three quarters due to the rise in rates in commercial banks. For instance, prices have dropped by an average of 5.5% in Germany, 4.5% in the Netherlands, and 11.5% on the secondary market in Germany. While prices in Italy and France are still close to peak values.
Who is under pressure?
Europe is entering a period of challenges in adapting its economy to a significantly higher level of rates. This will not only lead to a recession but also increase the risk of a financial crisis in three main sectors that are sensitive to the cost of money.
The first sector is corporate borrowers, who will have to pay higher bills for utilities and salaries and more interest on borrowed funds. The next two years may prove to be difficult for the most heavily indebted, especially if the recession also reduces their revenue. In 2022, the total volume of the riskiest euro-denominated Collateralized Loan Obligations (CLO) and “junk” bonds reached €308 billion and €404.5 billion, respectively.
Secondly, the increase in the cost of borrowing for mortgages and consumer loans will also cause households’ debt service ratio to rise. The ECB has calculated that households in the eurozone spend an average of 20% of their disposable income on repaying loans.
Thirdly, borrowers defaulting on loans will cause banks to deal with an increase in loan losses. The European Banking Authority predicts that EU banks’ average non-performing loan ratio will rise from 2.8% in 2021 to 3.7% in 2023, resulting in an additional €200 billion in bad debts. This will exert pressure on banks’ capital adequacy ratios and their capacity to lend.