Low Interest Rates in EU and China, European Policy Response

Real estate overvaluation could become an important currency mover. Yesterday, it was ECB’s Draghi warning about the unwanted side effects of keeping rates low for too long. Ironically, the ECB seems to have no other option to keeping monetary accommodation in place given peripheral bond and bank vulnerability. Hence, macro-prudential measures may have to do the job of cooling down the real estate markets. Draghi suggested that there were eight EMU countries facing misallocation risks into real estate. When bubbles are in the making the effects are reflationary, but when bubbles burst modest reflation can turn into difficult to control deflationary pressures as witnessed during the US sub-prime crisis

Draghi citing mis-allocation risks is another form of admitting that there are strong diverging economic trends working in the Eurozone. The lack of an adequate fiscal response – most optimal via a fiscal transfer from core into peripheral countries – leaves the adjustment burden entirely with the ECB. However,a one-currency fits all approach does not allow for monetary policy specification, i.e tightening monetary conditions in the core while loosening conditions in the peripheral. Instead, the ECB has to apply monetary policy according to the needs of EMU’s weakest links. Asset booms in core EMU countries are the result. Whether macro-prudential measures are sufficient to ease diverging asset prices trends may be doubted given the experience of other countries using macro-prudential policy.

China has addressed its real estate mis-allocation risk by tightening its monetary and easing its fiscal policy. Latest house volume sales numbers showed a significant reduction in activity. According to a survey provided by the China Index Academy, highlighted in today’s Economic Information Daily, sales volume has declined by 21.9%Y.For EMU to avoid misallocation risk within core countries, tighter monetary conditions would be required. However, the absence of a fiscal option – consider limitations provided by the German debt break introduced in 2009 (and then broader EMU by the Fiscal compact in 2012) – the ECB has no other choice than keeping monetary accommodation in place.

The BTP market acts as EMU’s risk barometer. Markets have remained nervous ahead of Italy’s Senate referendum comingup this Sunday. By now the linkages between the Italian banking sector and the BTP are well understood by market participants as was proved yesterday when BTP spread widening did lead to the Italian bank index falling back towards early October lows. Hence, the ECB may keep its security purchase program in place, indirectly providing support for Italian banks. While this policy is directed towards EMU’s weakest links it may be the core countries seeing the best of expansionary economic impact. The core countries closing their output gaps will produce higher inflation rates which in conjunction with lower core bond yields should depress real yields while peripheral real yields may be pushed higher via rising credit risks and resilient deflationary pressures.