Corporate and bank stock prices (European Union, 100=Dec. 2019)
Source: Refinitiv and EIB calculations.
Note: Last record, 4 November 2020.
The initial contraction could have easily turned into a financial collapse. At the onset of the crisis, the stock market plunged, with corporate stock prices indices plummeting by 35% and bank stocks by 40% as investors fled to safer assets (Figure 14). However, a massive and unprecedented response by central banks and governments prevented a financial collapse from compounding the freefall in output. Share prices recovered strongly for corporate stocks, whose performance was uncoupled from bank stocks. Nine months after the start of the crisis, in late November 2020, bank stocks are still 30% below pre-crisis levels. In the longer term, banks´ profitability is likely to remain subdued, given the persistent low interest rate environment that is squeezing net interest income and the returns from maturity transformation.
The ECB swiftly dispelled initial fears about the integrity of the euro area. In Figure 15, we plot quanto CDS spreads, or the difference between credit default swap quotes in US dollars and euros. The resulting measure is an indication of the risk associated with the break-up of the euro area as perceived by investors.[6] In contrast to what happened during the sovereign debt crisis, the quanto CDS spreads did not escalate for the three major sovereigns – France, Italy and Spain – compared to Germany, and stayed almost unchanged compared to the period prior to the COVID-19 crisis. This suggests that the ECB’s response was perceived as bold enough to support the integrity of the euro area.
Lower inflation for longer. At its onset, some analysts argued that the crisis could have a negative or positive impact on inflation (Shapiro, 2020). Since the lockdown has resulted in both an adverse supply shock and an adverse demand shock, inflation could theoretically have responded either way. In the first few months, however, inflation slowed down sharply across Europe, and the decline was due to other factors than the most volatile components, such as energy (Figure 16). In the long term however, the risk of inflation rising beyond its target is substantial given the amount of liquidity injected in the system. Moreover, as public debt accumulates, monetary policy may well give way to fiscal constraints (come under fiscal dominance), if rate hikes are seen as doing too much damage to public finances.[7]
Figure 15
Quanto CDS spreads (basis points)
Source: Refinitiv and EIB calculations.
Note: Last record, October 2020.
Figure 16
EU Harmonised Index of consumer prices and dispersion (annual rate, %, and interquartile quartile range, in percentage points)
Source: Eurostat and EIB calculations.
Note: Last record September 2020.
Major central banks entered the crisis with little leeway for lowering short-term policy rates. Figure 17 plots the interbank money market rates for the three major advanced economies. While the US Federal Reserve had embarked on tightening its monetary policy, the ECB and Bank of Japan were already deploying negative short-term rates close to the effective zero lower bound. Consequently, only the United States had some latitude to use standard monetary policy to support the economy. From February 2020 until October 2020, the effective federal funds rate decreased by 150 basis points in the United States.
Long-term rates also were already low prior to the crisis. Several structural drivers were already fuelling the downward trend in long-term interest rates (Figure 18). While monetary policy can be a contributor, demographic changes are a major cause. As the populations in advanced economies age, the balance between the various age groups in these populations shifts, affecting the overall supply of savings. Middle-aged individuals tend to save and provide funds to the rest of the economy, while the young and the old tend to spend more than their disposable income and demand funds. As a result, the real interest rate that balances the overall supply of savings with the demand for investment is affected by the relative size of these age groups (del Negro et al., 2018).
Long-term rates are most likely to remain low for longer, and might even drop further. While the rapid and unprecedented collapse of production, trade and employment may be reversed when the pandemic eases, historical data suggest that long-term economic consequences could persist (Jordà et al., 2020). Among these are a prolonged period of depressed real interest rates – akin to secular stagnation – that may linger for a long time. Chudik et al. (2020) estimate that the pandemic will likely drive long-term interest rates in the advanced economies about 100 basis points lower than their pre-COVID-19 lows over the next few years. This is because the crisis raises precautionary savings and dampens investment demand.
Figure 17
Short-term interest rates in selected advanced economies (% per year)
Source: Refinitv and EIB calculations.
Note: Last record October 2020.
Figure 18
Long-term interest rates in selected advanced economies (% per year)
Source: Refinitiv.
Note: Last record November 2020.
With increasing capital inflows and an appreciating exchange rate, Europe is perceived as resilient. Figure 19 plots net portfolio inflows in the euro area and the euro effective exchange rate. Since the start of the crisis, both have clearly been on a positive trend. From February 2020 until October 2020, the effective exchange rate of the euro, the exchange rate against a basket of currencies, increased by 7%. The stronger exchange rate partly reflected the trend in cumulative annual capital flows, which increased by more than 2% of GDP over the same period, with a shift from net outflows to net inflows. These developments suggest that during the crisis, the European Union’s performance, which was partly the result of the policy response, was perceived as credible and reassuring by international investors. Over the same period, the European Commission issued the first tranche of bonds to finance the SURE instrument (Support to Mitigate Unemployment Risks in an Emergency) and the recovery plan. The issuance was a major success, and was largely oversubscribed. This bodes well for the future of these bonds as a potential safe asset for investors, and also for the financing of the green transition.
A central bank with two arms
For the first time, the ECB acted both on monetary policy and on financial prudential policy. To ensure financial prudency, macro and micro policy measures were deployed. Following the global financial crisis, the ECB became in charge of the micro-supervision of euro area banks while the European Systemic Risk Board (ESRB) was created to coordinate macro-prudential policies across Europe. The COVID-19 crisis provided the