Keeping an eye on risks? The economic situation in Germany and Europe Annual reception of the Bundesbank’s Regional Office in Hamburg
Ladies and gentlemen
I, too, am delighted to have the opportunity of welcoming you to the no-longer-so-New Year – may it deliver all the things you have been hoping for. I am very pleased to be here in Hamburg and, especially, to have the privilege of welcoming Dr Peters, the president of the German Banking Association.
I am also glad to see, alongside Dr Peters, the faces of a whole bunch of other people whom I have met up with here in Hamburg in the recent past. These meetings involved HSH Nordbank, the sale of which is now entering the decisive phase. The deadline given by the European Commission for privatisation in connection with state aid is 28 February. As a provider of finance and an employer, HSH Nordbank is a key player for the economy of northern Germany, and further afield. Given the significance of this event, it is particularly important to find a good, deliverable and sustainable solution in the selling-off process. And this, too, is an opportunity for Germany to demonstrate its ability to deal with European Commission decisions in a responsible manner.
The good news is that Germany’s banking sector has become significantly more attractive in the past few years, as is evinced, for instance, by investment in German banks in the past few months. It would be very welcome for all parties involved if this trend were also to expand to include HSH Nordbank.
At all events, we at the Bundesbank are closely monitoring and observing developments concerning the sale. We are well aware of the import of the forthcoming decision, and the same goes, I am sure, for the federal states of Hamburg and Schleswig-Holstein.
However, let me now come to the actual topic of my talk. In a draft version of my lecture, one of my staffers suggested that I use the beautiful view of the city from up here on the “panoramic deck” to introduce my remarks using the image of “far-sightedness”. After all, my remarks are about the state of the economy in Germany and the euro area as a whole, about economic forecasts and whether we can see all the risks to future developments.
I initially liked the idea, until I realised one thing: where would it leave me if suddenly – speaking only hypothetically, of course – a bank of fog or drizzle suddenly descends over Hamburg, leaving us all to stare out right into a solid grey wall? An entry to a speech, the impact of which depends on the weather in Hamburg, can be described as anything from brave to brash – for a Bundesbanker, this is not an option.
What I can promise you, however, is to dare to look far, beyond the economic situation in the euro area to cover, amongst other things, political and institutional developments in Europe.
2 The economic situation in Germany and the euro area
Whereas the forecast for the euro area economy is clear and sunny, this situation has been the case for Germany for quite some time already. In 2017, GDP growth in this country outstripped the potential growth rate for the fourth consecutive year. Initial calculations by the Federal Statistical Office indicate that in 2017 real GDP rose by 2.5 % in calendar-adjusted terms. What is particularly pleasing to hear is that the upswing is now broadly based, ie it is rippling across many areas of the economy, with industrial activity making a major contribution to growth. And beneficial side-effects of the healthy economy are now the lowest unemployment rate since German reunification and record employment levels.
Now the euro area is also witnessing a fully-fledged upswing, whereas in the past there had been talk of only a gradual recovery. In 2017, economic activity grew at a faster pace each quarter than it had in the same quarter a year earlier. By year-end, GDP had climbed by 2.4 % overall. And this is also having a knock-on effect on unemployment in the euro area, which just a few years ago had been giving us considerably greater headaches. At 8.7 % in December of 2017, it was well below its peak of 12.1% reached in 2013, putting it at its lowest level since January 2009. This indicates that the stable upward trend in the labour market has continued on the back of buoyant activity. Employment growth even accelerated in 2017 compared with the previous year. There is therefore no doubt that the upswing has finally made it to the European labour market. Admittedly, this has not resolved the concerns about high youth unemployment and its social consequences in some member states, but developments have at least boosted confidence. And, according to a recent survey by Ernst & Young, 1.8 million new jobs are likely to be created in the euro area in the course of 2018.
It is important that the euro area upswing is no longer confined to just a small set of countries and sectors but is instead perched on a much broader base. This development is also mirrored in the favourable economic climate. Although the European Commission business sentiment indicator recently dipped a bit, it is still entrenched at a very high level. The great confidence of firms and households in the economy suggests that the upswing will continue.
And, indeed, the economic outlook for the euro area is looking good, as we are seeing not least for Germany. The Bundesbank expects a further GDP increase of 2.5 % this year. And in 2019 (+1.7 %) and 2020 (+1.5 %), Germany will still exceed its potential growth.
Experts from both the IMF and the ECB have recently revised upwards their growth expectations for the euro area. The December 2017 Eurosystem staff macroeconomic projections foresee annual real GDP increasing by 2.3 % in 2018, 1.9 % in 2019 and 1.7 % in 2020. Compared with the September 2017 projections, the outlook for GDP growth has therefore been revised upwards substantially.
The key factor here is robust domestic demand, which is benefiting from the ongoing improvement in the labour market and favourable funding conditions. But solid global economic growth is also playing its part in the upswing. The IMF, for instance, estimates that the global economy will grow 3.9 % in 2018 (a figure which was just revised upwards in January). If this happens, then global economic growth potential will be almost fully achieved for the first time since 2008.
3 Keeping an eye on all risks?
You have had to digest a whole battery of key economic figures – even among experts, it is understandable if one or another person is slowly overcome by an internal bank of fog. However, I would like to stress that statements on the economic situation are ultimately nothing more than snapshots at a given moment in time. The further we look into the future, the more important it is to cautiously put these figures into context: how secure is the outlook actually? And are we keeping a sufficient eye on all risks? I will address the latter question in part two of my remarks.
The early warning indicators that we observe do not currently point to a heightened risk situation. Some indicators, such as the number of corporate insolvencies, are at all-time low levels.
However, there remains no alternative but to keep a constant watch on individual indicators. After all, of course, even in times of an economic upswing, risks in the financial system won’t just disappear. Global geopolitical risks will continue to exist in the longer term. The UK referendum one and a half years ago, in which a majority voted to leave the EU, has created additional risks and uncertainty.
To calm your nerves: I will not follow the statistical part with a definitive list of downside risks. However, if we are going to look at the positive outlook for the economy, we should examine precisely those risks which, in an upswing, are likewise “booming”.
One type that seems particularly important to me is interest rate risk, which is created by changes in the general level of interest rates. Although this type of risk is a classical banking risk, it is not captured by the first pillar of the Basel framework. We therefore monitor banks’ interest rate risk within the framework of the Supervisory Review Process. An important metric in this context is the “Basel interest rate shock”, which simulates an immediate 200-basis-point rise and an immediate 200-basis-point fall in the yield curve parallel to the starting level. If, in either of these scenarios, losses exceed 20 % of capital, interest rate risk is said to be elevated. This is now affecting nearly one bank in two in Germany.
What is important to us as supervisors is this: institutions have to demonstrate that they have these risks under control, or that they have a sufficient capital buffer. In this connection, the current low-interest-rate environment poses a particular challenge. Banks and savings banks have recently considerably expanded their loans with an interest rate lock-in period of over ten years, whereas, by contrast, shorter lock-in periods and variable interest rates have become less prevalent. In technical terms, therefore, banks’ maturity transformation has increased.
The upswing therefore contains its own set of risks. And experience teaches us that, when the economy is good, risks tend to be underestimated. This is particularly true of financial markets. This was described by Hyman Minsky, who, as early as the 1980s, pointed out that people generally simply assume that positive developments will continue in the future, and, through their overoptimistic expectations and thus excessive risk appetite, cause bubbles to form. Financial markets therefore tend to be unstable. According to Minsky, the risk of such unthinking optimism is particularly high during prolonged phases of growth.
This can affect many areas – such as the real estate sector. Prices in that segment are being monitored extremely closely. In 2016, real estate prices across Germany were up by 7.7 % on the year. By the way, here in northern Germany, residential property prices rose almost as sharply over the same period, by 7.2 %. And also seen over a relatively long term, ie since real estate market prices began to rise in 2010, annual inflation in this sector in northern Germany, averaging 5.3 %, was just as high as in the entire Federal Republic. Prices are therefore going up strongly not only throughout the nation but also in northern Germany, which invites us to take a closer look. In the area of residential property, for instance, overvaluation in urban areas continued to rise over the past year. And most recently, credit standards for housing loans were eased slightly, too. Viewed the past few years as a whole, however, we see no evidence of a major fall-off in credit standards. However, owing to the size and significance of the real estate sector for the banking industry, developments in this sector will have to be monitored continuously.
4 Structural risks in the euro area
There are also risks to the euro area. We ought not to succumb to euphoria over the positive economic data for the euro area – after all, many euro area countries continue to face great challenges. The government budgets of many euro area countries remain vulnerable to shocks. And as for the foreseeable fiscal consequences of an ageing population, for instance, now would be the right time to use the currently very favourable budgetary situation to equip ourselves to deal with them.
Yet the stiffest challenge continues to lie in giving the single currency a robust and consistent structural framework. The structural integrity of the euro area has been found wanting. A few years ago, we saw how doubts about the fiscal soundness of individual member states ultimately led to doubts about the cohesion of the euro area as a whole. These doubts could only be appeased with the aid of government bailout programmes and Eurosystem measures. Yet we don’t have a solution that addresses the structural problems, not even now. Against this background, the fact that the policy debate on the deepening of European integration and on ways of ensuring the long-term stability of the euro area has picked up steam is a positive sign. A decisive factor in this debate, in my opinion, is that the measures aim at greater observance in future of the necessary balance between actions and liability for their consequences. After all, only those who take decisions for which they will be liable for the consequences will act in a responsible manner.
One area where we see the need to improve the structural integrity of monetary union is in the relationships of mutual dependency between governments and their domestic banks, known as the sovereign-bank nexus. This nexus could jeopardise the overall stability of the European financial system in the event that the debt of a euro area member state is restructured. This problem was very virulent during the euro area crisis and has still not been fully resolved. Credit institutions still hold substantial loan portfolios on the domestic public sector. Measured in terms of their claims on the general governments of all euro area member states, this share has even grown over the past ten years; in other words, the sovereign-bank nexus has become even more entrenched.
As part of the work on banking union, initial steps have already been introduced. European supervisors can boast key achievements. One is that banks in some euro area member states – not least thanks to pressure from supervisors – have shrunk their large portfolios of non-performing loans, in some cases substantially. Yet one thing is clear: not even the current economic upturn will relieve the affected institutions of the need to tackle a task that still remains a challenge, ie of resolutely continuing to scale back their portfolios of non-performing loans.
Another thing is important: new institutions such as the SSM must not be left to fend for themselves when it comes to solving structural problems. Flanking measures are necessary. Rules for setting aside capital against the risks of sovereign bonds would contribute to making banks think more rationally in economic terms when they purchase public sector bonds. For these and other structural problems afflicting the euro area, we must therefore see to it that our problem-solving approaches are characterised by far-sightedness in that we address the actual root problems themselves.
5 Far-sightedness is what is needed
Ladies and gentlemen, I’ve actually managed to mention the buzzword “far-sightedness” by name towards the end of my remarks. It might not work well for the beginning, but will certainly be a good way for me to end my talk. Given the currently favourable economic environment in the euro area, we cannot allow the figures to lull us into complacency. There are two tasks which I would like to emphasise once again.
- The good outlook for the economy should not fog up our vision. There are still risks, most of which are well known to us. These include interest rate risk or real estate risk. And, in a long-term view, the benefits of having a suitable sense of risk are indisputable.
- We must also tackle the structural risks to the euro area in a far-sighted manner. A broad based economic upswing is the best time window I can think of to conduct reforms.
Moreover, in international affairs, too, far-sightedness is a topical issue. This concerns, not least, the issue of protectionism. Naturally, structural change poses a daunting challenge to the industrialised world, too. However, protective tariffs are not the right answer, as they harbour the threat of countermeasures that could spiral into a trade war – one that would ultimately only produce losers. While going it alone may seem like a particularly sophisticated approach for some countries, it will ultimately turn out to be rather short-sighted.
Thank you for your attention.
- US economist (1919-1996).