The theme of returning stability and investor confidence in the eurozone underpinned European Central Bank Executive Board Member Yves Mersch’s closing keynote address at the Sixth Annual European Investment Conference in London. According to Mersch, the newfound calm in European financial markets — evidenced by the return of foreign capital flows, declining financial fragmentation among eurozone economies, and the halting of contagion — reflects the credibility of reform initiatives enacted in the wake of the financial crisis.
Mersch began his talk by explaining the original design flaws of European monetary union (EMU) and how recent policy initiatives have sought to address the problems brought about by those flaws. These deficiencies, he contended, included the lack of implementation and enforcement of the Maastricht stability and growth criteria establishing limits on fiscal deficits and government indebtedness; the absence of a mechanism to address macroeconomic imbalances among member states; and the lack of an institutional framework to monitor systemic risks and create a level playing field in the European banking sector.
Recent measures to bolster the architecture of EMU, coupled with strengthened political resolve, have begun to address these problems, Mersch said. For example, national fiscal reforms and enhanced governance and surveillance over budgetary frameworks at the European level have begun to bear fruit. He illustrated this point by noting that the fiscal deficit of the euro area (3.1%) now compares favorably against both the United States (5.8%) and Japan (more than 9%). In addition, gross debt in the euro area, amounting to 96% of GDP, is lower than both the United States and Japan, at 106% and 244%, respectively.
Moreover, Mersch argued, the banking union — which, to date, comprises plans for a single supervisory mechanism (SSM) and a single resolution mechanism (SRM) — will ensure a level playing field for banks operating across borders as well as a higher level of sector integration. He outlined three priorities for the ECB over the next year in its new role as the single supervisor for the largest euro-area banks. These include conducting a supervisory risk assessment (examining bank capital and liquidity), an asset quality review (examining point-in-time risk exposures), and stress tests (a forward-looking assessment examining banks’ loss absorption capacity). These measures should bring about greater transparency and investor confidence in the European banking sector and in turn help alleviate the divergence in funding costs among issuers in core versus peripheral European countries.
Mersch went on to discuss recent trends in financial markets in the context of these reforms and specifically addressed the increase in capital flows into the euro area, the absence of contagion effects in response to adverse news (such as political instability in Italy and Portugal), and the aforementioned reduction in financial fragmentation. On this latter point, Mersch noted that the reduction in borrowing costs and fragmentation among countries was not confined to sovereign issuers. There has been a reduction in the dispersion of the cost of debt funding for banks; additionally, non-financial corporate bond spreads have also followed a downward trend, he noted. The ongoing repayment to the European Central Bank of LTRO funds (Long-Term Refinancing Operations) further reflects the easing of funding difficulties among banks.
The central banker reiterated, in closing, that these financial market trends reflected the credibility of the reform measures undertaken. But Mersch also asserted that more needs to be done and specifically highlighted the fact that financing of the real economy via the banking channel needs to resume, along with an enhanced role for capital markets–based financing, particularly via a revival of the securitization market to support access to finance for small- and medium-sized enterprises.
As policymakers lay the institutional foundations for a strengthened euro area financial system, the path to stability has been established. Investors must now hope that growth resumes.
Watch Yves Mersch’s full presentation below:
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