In an unexpected two-part warning from the ECB, the European Central Bank warned of “excessive exuberance” in some European housing markets, driven by offshore buyers, that could spread to other areas in a “ripple effect.” Separately, the ECB also said "debt-sustainability concerns" have risen in the past six months amid a potential increase in yields and political uncertainty in some countries.
We start with the latter warning, which we find ironic as it is a function of the ECB's own policies of keeping rates suppressed at record lows to promote inflation, and now that inflation has finally emerged, the ECB is worried about the spillover and unwind of its policies. "Risks to financial stability stemming from financial markets remain significant,” the ECB said in its Financial Stability Review. An abrupt bond-market repricing could “materialize via spillovers from higher yields in advanced economies, in particular the United States.”
The ECB also warned that euro-area banks remain vulnerable as low interest rates and a big stock of non-performing loans in some regions challenge profitability. It cited structural challenges in the industry, including overcapacity and too little income diversification.
In Italy, which has one of the euro region’s highest debt ratios and where the government is trying to finalize a plan to rescue Banca Monte dei Paschi di Siena SpA, business lobby Confindustria said on Wednesday that the country must “be ready for when the ECB will end sovereign bond purchases” according to Bloomberg. This means “quickly lowering the mountain of public debt through privatizations and sale of state-owned real estate,” Chairman Vincenzo Boccia said in Rome.
While it did not show it, the chart below from Goldman summarizes the threat: a normalization of European rates would result in double digit principal losses for bondholders in countries like German, Spain, France and Italy... but not if they sell first to other "greater fools." It is this transition from a stable to a chaotic market, that is currently troubling the central bank.
Two steps ahead of the ECB, the Fed has already raised rates twice since late last year and policy makers predict two more hikes in 2017. In Europe, an exit from unconventional stimulus is also moving closer, even though officials caution that quantitative easing must be unwound very gradually before higher borrowing costs should even be discussed.
As it has done repeatedly in recent months, the ECB report also warned that Brexit “contributes to prevailing political uncertainties,” but said the impact on financial stability should be limited as long as banks take proper action in time. It sees a low risk of the euro-area economy facing restrictions in accessing financial services after Britain’s departure from the European Union.
“Well-managed preparations will be essential as a relocation of financial services capacity during the transition from the current situation to the new equilibrium could, in some cases, face frictions,” according to the report. “Therefore, the ECB underlines the need for the concerned banks and other financial institutions to undertake all the necessary preparations in a timely manner.”
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Separately, in a warning that resident of Vancouver and Toronto will appreciate, the central bank also cautioned that since 2010, house prices in European capital cities have risen far more than national averages. The ECB cited Berlin, Paris, Vienna and Amsterdam as cities that have performed particularly well.
While it did not use the words irrational exuberance, it came close, when the ECB said that “exuberant house price developments in certain regions could, in principle, threaten the stability of financial institutions with mortgage exposures concentrated in those regions."
Although diverging developments at the regional level could be justified by fundamentals, such as differences in regional income, employment, population dynamics and amenities, they could also signal excessive exuberance of house prices in certain areas, for example due to the strong presence of foreign buyers
While hardly rocket science, Bloomberg points out that record-low interest rates have fueled demand for residential properties as investors seek to buy assets that generate returns rather than depositing their money in banks. That has benefited housing markets in Germany, France and the Netherlands, as well as Estonia and Ireland, the ECB said.
Compounding the problem, the central bank warned that elevated levels of household indebtedness and large real estate exposures of banks in countries such as Finland and the Netherlands could “amplify” shocks. The central bank said it’s monitoring property-market developments closely and may top up national measures if necessary.
To which all we can say is that we wish the ECB, which created all the problems it now complains about, the best of luck as it scrambles to contain the genie inside the bottle.