…and what they mean for the economy, strategy and investments
The key chart
12-month cumulative flows (EUR bn) presented in a stylised consolidated balance sheet format (Source: ECB; CMMP)
Starting with three things about the nature of money:
Money has taken various forms over time (gold, silver etc) but comes largely in two main forms today – cash and (electronic) bank deposits
Money held electronically in the form of bank deposits represents 85% of total money in the euro area. Physical holdings in the form of bank notes and/or cash represent less than 10%
Money is “created” primarily when banks make loans, and also when governments spend (hence concepts such as the “money multiplier” and “loanable funds theory” are redundant today)
Next, three things about how money is measured:
Money is typically measured in the form of “monetary aggregates”, derived from the liabilities side of the consolidated balance sheet of monetary financial institutions (see key chart above). It is then classified according to its liquidity or degree of “moneyness” e.g. narrow money (M1, the most liquid), intermediate money (M2), and then broad money (M3), in the case of the euro area
The calculation of money supply involves adding these components together – in essence, the sum of currency in circulation plus the outstanding amount of financial instruments that have a high degree of moneyness. The simplest way to think about money, therefore, is as the short-term liabilities of the banking sector (note that longer-term liabilities are excluded from the definition of broad money as they considered portfolio instruments rather than as a means of transacting)
M3 = M1 (currency plus overnight deposits) plus M2-M1 (other ST deposits) plus M3-M2 (marketable instruments)
Money can also be calculated and understood by re-arranging the so-called “counterparts of money”, i.e. all items other than money on both sides of the consolidated balance sheet. Hence M3 in the euro area can also be calculated as:
M3 = credit to EA residents + net external assets – longer term liabilities + other counterparts
Finally, what are the three key messages from current trends in EA monetary aggregates?
The headline YoY decline in broad money in August 2023 (-1.3% YoY) reflects an on-going arbitrage in favour of the highest remunerated deposits (and also bank securities outside M3) rather than a lack of confidence in the region’s banks. The very slow/limited pass through of higher policy rates to the rates offered on overnight deposits is the key reason here and is a unique feature of the current tightening cycle. While cumulative 12-month flows into other ST deposits (€855bn) and marketable securities (€154bn) have been insufficient to compensate fully for the outflows of currency and overnight deposits (€1,226bn) they also need to be considered together with the flows into longer term bank liabilities (€298bn).
Financing flows to the private sector, while positive, are slowing very sharply. Cumulative monthly flows of credit to the private sector fell from €813bn in the 12 months to August 2022 to only €85bn in the 12 months to August 2023. Within this the respective flows of bank loans fell from €782bn to only €16bn.
This pace of adjustment in financing flows highlights the rising risk of policy errors from the ECB, which lacks a playbook for the most aggressive period of monetary tightening in its history.
Please note that the summary comments and chart above are abstracts from more detailed analysis that is available separately.
Cumulative 12-month flows fell from €782bn in August 2022 to only €16bn in August 2022.
In response to the rapid transmission of ECB monetary tightening to the cost of corporate (NFC) borrowing, EA NFCs have repaid loans in seven of the past 10 months. Cumulative 12-month flows of NFC lending fell from €390bn in the 12 months to October 2022 to only €3bn in the 12 month to August 2023.
EA households (HHs) have repaid loans in two of the past four months. Cumulative 12-month flows of HH lending fell from €285bn in the 12 months to June 2922 to only €30bn in the 12 months to August 2023. This slowdown reflects mortgage dynamics primarily.
As described in previous posts, the ECB lacks a playbook for the most aggressive period of monetary tightening in its history. The pace of adjustment in financing flows suggest that the risks of policy errors are rising sharply. The ECB had reasons to pause this month but chose instead to raise rates for the tenth time to 4%.
Philip Lane argued recently that, “all of the signals are there that monetary policy is working.” As financing flows approach a choke point, the risk is that the ECB’s blunt instruments work too well. Time to pause…
The charts that matter
The collapse in financing flows to the EA private sector since 2019 (Source: ECB; CMMP)
EA NFCs have repaid loans in seven of the past ten months (Source: ECB; CMMP)
EA HHs have repaid loans in two of the past four months (Source: ECB; CMMP)
Slowdown in financing flows to the HH sector reflects mortgage market dynamics primarily (Source: ECB; CMMP)
Please note that the summary comments and charts above are abstracts from more detailed analysis that is available separately.
How the French case study improves our understanding of debt dynamics
The key chart
Top ten BIS reporting nations ranked by outstanding stock of PS debt ($tr) (Source: BIS; CMMP)
The key message
France provides an excellent case study for improving our understanding of global debt dynamics and their impact on economic activity and banking sector risks.
When analysing debt dynamics, policy makers and macroeconomists are vulnerable to three types of mistakes:
Mistake #2: focusing exclusively on the absolute level of PS debt
Mistake #3: failing to incorporate the “structure” of debt into their analysis
Current French debt dynamics illustrate the impact of these mistakes in practice and highlight why a more multi-faceted, analytical approach is required.
Attention typically focuses on France’s above EU-average level of public debt and Economy Minister, Bruno Le Maire’s attempts to convince markets and Brussels that France is “going back to budget discipline” (see today’s 2024 budget announcement for details).
Note, however, that France also has the fourth highest outstanding stock of PS debt in the world ($6.6tr) and the highest outstanding stock among euro area (EA) nations. The risk here is that potential PS debt vulnerabilities are either ignored or under-played. Consider three additional factors:
the level of PS indebtedness: France has the highest level of PS indebtedness (226% GDP) among EA economies (excluding Luxembourg)
the rate of excess credit growth: France has recorded the highest levels of excess PS credit growth among larger EA economies since mid-2015
affordability risks: France’s PS debt service ratio is high in absolute terms and in relation to its LT average
Each of these factors point to elevated PS debt vulnerabilities in France, but they do not tell the whole story.
The transmission mechanism of ECB monetary policy to the French economy is relatively slow. The increase in the cost of borrowing for French corporates has been lower than in the rest of the EA and the current cost of borrowing for both corporates and households is lower than the EA average too. This reflects unique, structural factors of French financial markets (bias towards fixed rate lending, maturity of NFC debt, maximum debt-service-to-income ratios etc). These factors do not eliminate France’s PS debt vulnerabilities, but they do limit their impact, at least in the short term.
In short the key message here – illustrated clearly by French debt dynamics – is that not only does private sector debt matter, but also that it needs to be considered in relation to the level of indebtedness, its rate of growth, its affordability AND its structure.
Structure matters too
The context
Top ten BIS reporting nations ranked by outstanding stock of PS debt ($tr) (Source: BIS; CMMP)
France has the fourth highest outstanding stock of private sector debt ($6.6tr) among BIS reporting nations and the highest outstanding stock among EA economies (see graph above).
While France’s share of total global PS debt has fallen slightly from 3.8% in 1Q09 to 3.3% in 1Q23, its share of euro area (EA) debt has increased from 21.7% to a new high of 28.4% over the same period (see graph below).
Trends in market share of EA private sector debt (Source: BIS; CMMP)
Improving our understanding of PS debt dynamics
Three factors point to elevated PS debt vulnerabilities in France – the level of indebtedness, the rate of “excess credit growth”, and affordability risks.
France has the highest level of PS indebtedness among EA economies (excluding Luxembourg). The PS debt ratio has risen from 145% GDP in 1Q03 (109% NFC, 36% HH) to 226% GDP in 1Q23 (160% NFC, 66% HH). The PS debt ratio has fallen from its 4Q20 peak of 241% GDP but has exceeded the Netherlands’ PS debt ratio for the past two quarters (see chart above).
France has also recorded the highest levels of excess PS credit growth among larger EA economies. Since mid-2015, France’s “relative growth factor” (RGF) of private sector credit has been the highest among the larger EA economies. The RGF measures the CAGR in PS debt versus the CAGR in nominal GDP, calculated on a rolling 3-year basis. The contrast between France’s excess credit growth and the trends in the Netherlands, Italy and Spain pre-COVID are marked (see chart above).
Affordability risks
Global affordability risks – deviation of DSR from LT average plotted against current DSR level (Source: BIS; CMMP)
The PS debt ratio is also high in absolute terms and in relation to its LT average, suggesting elevated “affordability risks” (see chart above). At the end of 1Q23, France’s PS debt service ratio was 20.5%. This was down from its 4Q20 peak of 21.5% but remains high in absolute terms and 2.7ppt above its average level since 1999.
Structure matters too
Change in cost of NFC borrowing since June 2022 plotted against current cost of NFC borrowing (July 2023) (Source: ECB; CMMP)
The transmission of ECB monetary policy to the French economy is relatively slow, however, offsetting the vulnerabilities described above. The increase in the cost of borrowing for French corporates (NFCs) has been lower than in the rest of the EA (see chart above) and the current cost of borrowing for both NFCs and households (HHs) is lower than the EA average too (see chart below).
Cost of French and EA borrowing for NFCs and HHs as of July 2023 (Source: ECB; CMMP)
These trends reflect unique structural characteristics of the French market including relative exposure to fixed-, as opposed to variable-rate, lending and the maturity of debt.
Only 41% of new loans to HHs and NFCs in France are variable rate loans compared with an average of 66% across the EA. More noticeably, less than 3% of new mortgage loans in France are variable rate compared with an average of just over 20% for the EA.
According to the Banque de France, the debt of French NFCs also remains focused on long maturities (55% of outstanding bank loans and 43% of market debt have residual maturities of 5 years or more). The average interest rate in outstanding debt is therefore increasingly gradually and remains considerably lower than the cost of new borrowing – good news for borrowers, less positive for banks’ NIMs.
Conclusion
Policy makers and economists typically obsess about public sector debt while largely ignoring PS debt (mistake #1). When attention is given to PS debt, this typically focuses on its absolute level alone (mistake #2).
Incorporating the level of indebtedness, the rate of growth and the affordability of debt improves our understanding of PS debt dynamics and their potential impact on the economy considerably. However, as this French case study shows, it is an error to ignore the structure of debt too (potential mistake #3).
The level of PS indebtedness, the rate of excess PS credit growth and the affordability of PS debt all point to elevated PS vulnerabilities in France. The structure of French PS debt limits the impact of these vulnerabilities due the relatively slow transmission of ECB monetary policy, however, at least in the short term.
In summary, structure matters too…
Please note that the summary comments and charts above are abstracts from more detailed analysis that is available separately.
The ECB has reasons to pause, but that doesn’t meant that it will
The key chart
Changes in COB (ppt) since tightening began plotted against months since tightening began (Source: ECB; CMMP)
The key message
With the uniquely rapid “pass through” of monetary policy leading to a sharp slowdown in financing flows to the euro area private sector, the ECB has reasons to pause this month – but that doesn’t mean that it will.
Pause for thought
In a recent post, I highlighted the sharp slowdown in financing flows to the euro area (EA) private sector and the causal link to the relatively rapid pass through of ECB policy to the cost of borrowing for EA corporates (NFCs) and, to a lesser extent, the cost of borrowing for EA households (HHs).
This link was confirmed by Isabel Schnabel, a Member of the Executive Board of the ECB, in a speech on 31 August 2023.
“Bank lending flows to both firms and households have dropped sharply in recent months as banks have increased their lending rates and tightened their credit standards. Our bank lending survey confirms that the level of interest rates is a key reason behind the contraction in loan demand.”
Schnabel, 31 August 2023
The release of EA bank interest rate statistics for July 2023 on 1 September 2023 provided further evidence of the unique pace of increase in the cost of borrowing.
Trend in CCOB for NFCs since July 2008 (Source: ECB; CMMP)
The composite cost of borrowing (CCOB) for NFCs has risen 3.10ppt from 1.83% in June 2022 to 4.93% in July 2023, its highest level since November 2008 (see chart above).
The rate of increase is a defining feature of the current tightening cycle.
During the 2005-08 tightening cycle, the CCOB for NFCs rose only 1.12ppt over the same time period (13 months), and only 2.12ppt over the entire 32 month tightening period (see key chart above).
Trend in CCOB for HHs since July 2008 (Source: ECB; CMMP)
The CCOB for HHs has risen 1.78ppt from 1.97% in June 2022 to 3.75% in July 2023, its highest level since February 2012. During the 2005-08 tightening period, the CCOB for HHs rose 0.88ppt over the same time period (13 months) and 1.79ppt over the entire 32 month tightening period.
According to the most recent “Bank Lending Survey”, credit standards, particularly for loans to NFCs, are expected to tighten further in the coming months, albeit at a slower pause. The ECB also “expects the lagged effect of past policy rates to continue to dampen aggregate spending” (Schnabel, 31 August 2023).
Conclusion
In short, the ECB has reasons to pause this month but as conflicting assessments from Pierre Wunsch (a bit more probably needed) on 2 September 2023 and Mario Centeno (danger of doing too much) on 4 September 2023 suggest, that does not meant that they will.
“The lack of a historical precedent means that we can rely less on past experience”
(Schnabel, 31 August 2023)
As noted in previous posts, the ECB lacks a playbook for the most rapid period of monetary tightening in its history. The rapid pace of adjustment in financing flows experienced to date suggests that the risks of policy errors are rising rapidly with negative, potential impacts on the region’s future growth prospects.
Please note that the summary comments and charts above are abstracts from more detailed analysis that is available separately.
The impact of ECB policy on financing flows to the private sector
The key chart
Trends in cumulative monthly flows (12 months, EUR bn) of loans to the EA private sector (Source: ECB; CMMP)
The key message
Financing flows to the euro area (EA) private sector are slowing very sharply. This is unsurprising given the relatively rapid pass through of ECB policy to the cost of borrowing for EA corporates (NFCs) and, to a lesser extent, the cost of borrowing for EA households (HHs). Note that the composite cost of borrowing for NFCs has risen 2.96ppt in the twelve months since June 2022. This compares with a 2.12ppt increases over the whole 32 month, 2005-08 tightening period.
The risk here is that the ECB lacks a playbook for the most aggressive period of monetary tightening in its history. The rapid pace of adjustment in financing flows (see key chart above) suggests that the risk of policy errors are rising rapidly with negative, potential impacts on financing flows to the EA economy and to the region’s future growth prospects. Note again, that in aggregate, NFCs have already paid back loans in seven of the past nine months. The issue here is that the EA relies heavily on bank finance and the region needs more, not less, productive lending and investment.
The warning signs are clear. How will the “data dependent” ECB respond in September?
Flowing over a cliff edge
Trends in 12-month cumulative flows of credit to the private sector (EUR bn) (Source: ECB; CMMP)
Financing flows to the euro area (EA) private sector are slowing sharply. Cumulative monthly flows of credit to the private sector totalled €197bn in the 12 months to July 2023 down from €758bn in the 12 months to July 2022 (see chart above).
Changes in composite costs of borrowing (ppt) in months after start of policy tightening (Source: ECB; CMMP)
The slowdown in financing flows is unsurprising given the relatively rapid pass through of ECB policy tightening to the cost of borrowing (COB) for NFCs and, to a lesser extent, HHs (see chart above).
The composite COB for NFCs has risen 2.96ppt in the twelve months since June 2022. This compares with a 2.12ppt increases over the 32 month, 2005-08 tightening period. The composite COB for HHs has risen 1.73ppt in the twelve months since June 2022. Again, for context, this compares with a 1.79ppt increase over the longer 32 month, 2005-08 tightening period.
The risk here is that the ECB lacks a playbook for the most aggressive period of monetary tightening in its history.
Trends in monthly and cumulative 12m flows of lending to NFCs (EUR bn) (Source: ECB; CMMP)
In aggregate, NFCs have repaid loans in six of the past nine months (see chart above). Cumulative monthly flows have fallen from €390bn in the 12 months to October 2022 to only €85bn in the 12 months to July 2023.
Trends in monthly and cumulative 12m flows of lending to HHs (EUR bn) (Source: ECB; CMMP)
In aggregate, HHs have repaid loans in two of the past three months (in each case, mortgage loans). Cumulative monthly flows have fallen from €285bn in the 12 months to June 2022 to only €40bn in the 12 months to July 2023.
Trends in cumulative monthly flows of loans to HHs, mortgages and consumer credit (EUR bn) (Source: ECB; CMMP)
The rapid slowdown in monthly flows to HHs, reflects mortgage dynamics primarily (see chart above). The composite cost of mortgages has risen 1.73ppt since June 2022. Cumulative flows have fallen from €268bn in the 12 months to August 2021 to only €40bn in the 12 months to July 2023. Despite a 1.85ppt in the composite cost of consumer credit, monthly flows have remained relatively resilient. However, as described in early posts, the demand for consumer credit has lagged well below pre-pandemic levels.
Conclusion
In summary, the rapid pace of adjustment in financing flows described above suggests that the risk of policy errors are rising rapidly with negative, potential impacts on financing flows to the EA economy and to the region’s future growth prospects. The EA relies heavily on bank finance and the region needs more, not less, productive lending and investment.
The warning signs are clear. How will the “data dependent” ECB respond in September?
Please note that the summary comments and charts above are abstracts from more detailed analysis that is available separately.
The impact of ECB policy seen through 12-month cumulative flows
The key chart
12-month cumulative financing flows (EUR bn) presented in stylised consolidated balance sheet format (Source: ECB; CMMP)
The key message
Monetary developments in the euro area (EA) highlight the elevated risks of ECB policy errors and their potential, negative impact on financing flows to the EA economy.
Headline YoY growth numbers for broad money and its key component (narrow money) and counterpart (private sector credit) highlight the speed at which EA money and credit cycles are rolling over.
Broad money (M3) fell -0.4% YoY, the first annual decline since May 2010. Narrow money (M1) fell -9.2% YoY, driven by a 10.5% YoY decline in overnight deposits. Growth in private sector credit slowed to 1.6% YoY, the slowest annual rate of growth since May 2016. The warning signs are there…
Within broad money, arbitrage continues in favour of the highest remunerated deposits – depositors are actively seeking higher returns – but this is insufficient to compensate for outflows from overnight deposits. The very slow/limited pass through from higher policy rates to the cost of overnight deposits has been one of the unique features of the current hiking cycle.
Financing flows to the private sector, largely in the form of loans, remain positive in absolute terms. They are slowing very sharply on a cumulative 12-month basis, however (see next post for details).
In short, cumulative financing flows to the EA economy were -€96bn in the 12-months to July 2023, compared with flows of €1,574bn, €1,014bn and €92bn in the 12-months to July 2020, July 2021 and July 2022 respectively.
The risks of significant policy errors are rising with negative implications for financing flows to the EA economy. How will the “data-dependent” ECB respond in September?
The impact of ECB policy on financing flows to the EA economy
Headline YoY growth numbers for broad money and its key component (narrow money) and counterpart (private sector credit) highlight the speed at which EA money and credit cycles are rolling over (see chart below).
Growth rates (% YoY) in M3, M1 and PS credit (Source: ECB; CMMP)
Broad money (M3) fell -0.4% YoY, the first annual decline since May 2010. The outstanding stock of money (€15,957bn) has fallen -1.6% from its September 2022 peak (€16,214bn). Narrow money, the key component of broad money, fell -9.2% YoY, driven by a 10.5% YoY decline in overnight deposits. Growth in private sector credit, the key counterpart to broad money, slowed to 1.6% YoY, its slowest annual rate of growth since May 2016.
Recall that monetary aggregates are derived from the consolidated balance sheet of MFIs. The key components are found on the liabilities side of the balance sheet – narrow money (M1) which comprises currency in circulation, other short-term deposits (M2-M1) and marketable instruments (M3-M2). Note that longer-term liabilities are not part of M3 as they are regarded more as portfolio instrument than as a means of carrying out transactions. The key chart above presents 12-month cumulative flows in the form of a stylised consolidated balance sheet.
Growth rates (% YoY) in M1 and M2-M1 (Source: ECB; CMMP)
Within broad money, arbitrage continues in favour of the highest remunerated deposits but this is insufficient to compensate for outflows from overnight deposits. The annual growth rate in other short-term deposits (M2-M1) was 24% YoY in June and July 2023, the highest rate of growth since the start of the EMU. In contrast, the -9.2% YoY decline in narrow money was the sharpest contraction since the start of EMU (see chart above).
Monthly flows (EUR bn) in EA monetary aggregates (Source: ECB; CMMP)
The EA banking system has seen eleven consecutive months of outflows in overnight deposits (see chart above). The outflow of narrow money totalled -€1,072bn (see key chart above), overshadowing the positive inflows of €852bn and €153bn into other short-term deposits (M2-M1) and marketable securities (M3-M2) and, outside broad money, the €262bn inflow into longer-term financial liabilities (mainly debt securities issued by banks).
Note that the very slow/limited pass through from higher policy rates to the cost of overnight deposits has been one of the unique features of the current hiking cycle.
Trend in 12-month cumulative monthly flows of loans to the private sector (Source: ECB; CMMP)
Financing flows to the private sector, largely in the form of loans, remain positive in absolute terms. They are slowing sharply on a cumulative 12-month basis, however (see chart above and next post for details).
12-month cumulative financing flows (EUR bn) presented in stylised consolidated balance sheet format (Source: ECB; CMMP)
In short, cumulative financing flows were -€96bn in the 12-months to July 2023, compared with flows of €1,576bn, €1,014bn and €92bn in the 12-months to July 2020, July 2021 and July 2022 respectively.
The risks of significant policy errors are rising. How will a data-dependent ECB respond in September?
Please note that the summary charts and comments above are abstracts from more detailed analysis that is available separately.
Quarterly consumer credit flows expressed as a multiple of pre-pandemic average flows (Source: FRED; BoE; CMMP)
The key message
In May 2023, I asked, “have US and UK consumers read the recession script?” I noted that, “despite rising borrowing costs, quarterly consumer credit flows in 1Q23 remained above pre-pandemic levels. Fast-forward another quarter and the question remains largely the same – when will US and UK consumers read the recession script?
Contrasting consumer credit dynamics suggests divergent growth outlooks for investors and different challenges for the Federal Reserve, the Bank of England and the ECB.
US consumer credit demand has moderated from its elevated 2022 levels, but remains above pre-pandemic average levels. UK consumer credit demand remains surprisingly resilient, and above pre-pandemic levels too. Chair Powell and Governor Bailey face similar challenges as consumers continue to borrow to support consumption despite rising borrowing costs.
The contrast with consumer credit dynamics in the euro area (EA) is sharp. EA consumer credit demand remains subdued and well below pre-pandemic levels. President Lagarde faces a very different balancing act between weaker growth/recession and lower inflation.
In short, the messages from the US, UK and EA money sectors remind us that the risks of policy errors remain elevated in all three regions but for contrasting reasons…
When will US and UK consumers read the recession script?
Quarterly US consumer credit flows (Source: FRED; CMMP)
US consumer credit demand is moderating sharply but remains above pre-pandemic levels. Quarterly flows of consumer credit have fallen from $87bn in 4Q22 to $52bn in 1Q23 and $50bn in 2Q23, but remain above their pre-pandemic level of €45bn (see chart above).
Monthly US consumer credit flows (Source: FRED; CMMP)
The monthly flow of US consumer credit was more volatile during the 2Q23 (see chart above). Flows ranged from $22.3bn (1.5x pre-pandemic average) in April 2023 to only $9.5bn (0.6x pre-pandemic average) in May 2023 and then $17.8bn (1.2x pre-pandemic flow) in June 2023.
Quarterly UK consumer credit flows (Source: BoE; CMMP)
UK consumer credit demand remains surprisingly resilient. Quarterly flows increased from £3.1bn in 4Q22 to £4.5bn in 1Q23 and £4.3bn in 2Q23. These flows were 0.9x, 1.2x and 1.2x the pre-pandemic average quarterly flow of £3.6bn (see chart above).
Monthly UK consumer credit flows (Source: BoE; CMMP)
Monthly flows during the 2Q23 were £1.6bn, £1.1bn and £1.7bn in April, May and June 2023 respectively. These flows were 1.6x, 1.1x and 1.7x the pre-pandemic average flows respectively. (see chart above).
Quarterly EA consumer credit flows (Source: ECB; CMMP)
Euro area consumer credit demand remains consistently subdued, in sharp contrast to trends observed in both the US and the UK. Quarterly flows have fallen from €5.2bn in 4Q22 to €4.2bn in 1Q23 and €3.4bn in 2Q23, the lowest quarterly flow since 2Q21 (see chart above). Quarterly flows have failed to recover to their pre-pandemic level of €10.3bn.
Monthly EA consumer credit flows (Source: ECB; CMMP)
Monthly flows have also declined during the quarter from €2.0bn in April to €1.3bn in May to only €23m in June 2023 (see chart above). As noted in previous posts, the fact that demand for consumer credit remains very subdued in absolute terms and in relation to trends observed in the US and the UK makes the ECB’s tasks slightly easier (while elevating policy risks at the same time).
Conclusion
Contrasting consumer credit dynamics suggests divergent growth outlooks for investors and different challenges for the Federal Reserve, the Bank of England and the ECB.
Demand is moderating sharply in the US but remains resilient and above the levels seen pre-pandemic, at least so far. UK demand also remains surprisingly resilient and above pre-pandemic levels, at least for the time being (and as suggested by OBR forecasts). Chair Powell and Governor Bailey face similar challenges as consumers continue to borrow to support consumptions despite rising borrowing costs.
In contrast, the message from the money sector for EA growth is much weaker and presents President Lagarde with a very different balancing act between weaker growth/recession and lower inflation.
The risks of policy errors remain elevated in all three regions but for contrasting reasons…
Please note that the summary comments and charts above are abstracts from more detailed analysis that is available separately.
The sound of deflating UK and EA mortgage markets is getting even louder
The key chart
Monthly UK and EA mortgage flows (3m MVA) expressed as a multiple of pre-pandemic average flows (Source: BoE; CMMP)
The key message
The sound of deflating UK and EA mortgage markets increased further at the start of 2Q23, including the return of net mortgage repayments in the UK. More bad news and negative headlines followed in UK newspapers at the start of this week…
“Banks turn the screw with a weekend of worse mortgage rates”
The Times, 5 June 2023
UK monthly mortgage flow dynamics (LHS) and annual growth rate (RHS) (Source: BoE; CMMP)
According to the latest BoE statistics, borrowing of mortgage debt by UK individuals declined from net zero in March 2023 to net repayments of £1.4bn in April 2023. This represents the lowest level since the £1.8bn net repayments recorded in July 2021.
The BoE noted that, “If the period since the onset of the COVID-19 pandemic is excluded, net borrowing of mortgage debt was at its lowest level on record” (i.e. since April 1993). The 3m MVA of monthly flows fell to -£203m in April from £903m in March. The 3m MVA of monthly flows has been below pre-pandemic levels since November 2022.
The annual growth rate fell to 2.3% YoY, the slowest rate since September 2015. With approvals also falling from 51,500 in March to 48,700 in April, further weakness in monthly flows and annual growth rates are likely.
EA monthly mortgage flow dynamics (LHS) and annual growth rate (RHS) (Source: ECB; CMMP)
Monthly EA mortgage flows also slowed sharply in April 2023 according to the latest ECB statistics. The flow fell to €1.7bn in April from €7.5bn in March and €5.1bn in February. The 3m MVA average of mortgage flows fell to €4.7bn in April from €4.9bn in March, only 0.38x the pre-pandemic average flow. The annual growth rate fell to 3.0% YoY, the slowest rate since April 2018.
Weaknesses in mortgage flows matter for two important reasons:
First, mortgage demand typically displays a co-incident relationship with real GDP.
Second, and in this context, the message from the UK and EA money sectors is clear – central banks continue to tighten policy as the risks to the economic outlook intensify.
Please note that the summary comments and charts above are abstracts from more detailed analysis that is available separately.
Recent trends in monthly flows (EUR bn) and YoY growth rates in EA monetary aggregates (Source: ECB; CMMP)
The key message
If you wanted to “create panic” about euro area (EA) banks you could focus exclusively on negative YoY growth rates and monthly outflows in narrow money (M1), and then develop a narrative about money destruction and an impending credit crisis. After all, the EA is experiencing the fastest contraction in M1 since the creation of the Economic and Monetary Union in 1999, and banks have experienced eight consecutive months of negative flows in narrow money too.
Unfortunately, there are a number of problems associated with this “panic narrative”. It ignores simple concepts such as opportunity cost and portfolio rebalancing and mispresents the causal links in money creation.
The opportunity cost problem: unprecedented tightening by the ECB has led to a rapid increase in the opportunity cost of holding ON deposits, in contrast to most of the past decade. It has triggered a partial reallocation of ON deposits to other ST deposits. M2-M1 (other ST deposits) increased 21% YoY in April 2023 – also the fastest rate since the creation of the EMU.
The portfolio rebalancing problem: The phasing out of net asset purchases and TLTROs has incentivised the issuance of bank bonds (up €170bn) since September 2022. This has led to portfolio rebalancing away from deposits (down €200bn over the same period) to longer term liabilities that do not form part of monetary aggregates (by definition).
The causal link problem: the principal way in which bank deposits are created is through commercial banks making loans. Banks are not simply intermediaries that take in deposits and then lend them out (“loanable funds theory”). Instead, banks create money. Growth in private sector credit peaked in September 2022 (7.0% YoY) and has slowed to 3.3% in April 2023, however. This reflects the relatively rapid pass through from higher policy rates to the cost of borrowing, weaker loan demand and tighter credit standards. Slower credit growth implies slower deposit growth (ceteris paribus).
In short, recent EA monetary dynamics are unprecedented in some respects. They are not a cause for panic over EA banks, however. They reflect instead a combination of an increase in the opportunity cost of holding money, portfolio rebalancing, weaker credit demand and tighter credit standards.
This is not to suggest that the message from EA banks is a positive one. On the contrary, it remains one of weaker economic activity and a challenging policy context in which the ECB is expected to continue tightening as economic stresses mount.
An important message, but a very different one to the “bank panic narratives” seen elsewhere…
If you wanted to create panic about EA banks
Focus on narrow money
Growth rates (% YoY) in EA narrow money since 1999 (Source: ECB; CMMP)
Narrow money (M1) in the EA is contracting at the fastest rate since the creation of the Economic and Monetary Union (EMU) in 1999 (see chart above). The annual growth rate in M1 turned negative in January 2023 (-0.8%) and has decelerated each month since then: -2.7% YoY in February 2023; -4.2% YoY in March 2023 and -5.2% YoY in April 2023.
Monthly flows (EUR bn) in narrow money since June 2022 (Source: ECB; CMMP)
EA banks have also experienced eight consecutive monthly outflows of narrow money since September 2022, largely due to the outflow of overnight deposits. The outflow in April 2023 was €-75bn, compared with €-135bn in March 2023, and €-140bn in February 2023 (see chart above).
From here, it is tempting to create a “panic narrative” for EA banks. Tempting, but wrong…
Problems with the panic narrative – “opportunity cost”
Growth rate in M3 (% YoY) and contribution from ON deposits and other components (ppt) (Source: ECB; CMMP)
The first problem with the panic narrative is that it ignores the fundamental economic concept of opportunity cost.
Note that for most of the past decade, narrow money has been the main driver of EA broad money growth. The chart above illustrates the growth rate in broad money (M3) and the contributions to growth made by ON deposits (the light blue columns) and all other M3 components (the maroon columns).
The exceptionally large contribution and accumulation of ON deposits in the EA (and elsewhere) over the period reflects (1) the extended period of low interest rates and, more recently, (2) the COVID-19 pandemic. Unorthodox monetary policy reduced the opportunity cost of holding ON deposits dramatically and the pandemic resulted in a sharp rise in both forced and precautionary savings.
Policy tightening by the ECB since June 2022 has been notable for both its scale and pace. The pass through from higher policy rates to the cost of overnight deposits has been very slow/limited and has lagged the pass through to the cost of other forms of ST deposits, however.
In short, the opportunity cost of holding ON deposits has risen rapidly since the start of policy tightening.
Spread between rates on other HH ST deposits and HH ON deposits (ppt) (Source: ECB; CMMP)
The chart above illustrates the spread (or opportunity cost) between HH deposits redeemable at notice of up to three months and deposits with an agreed maturity of up to two years – the components of M2-M1 – versus HH ON deposits over the past 20 years.
The opportunity costs of holding notice deposits, and terms deposits with maturities of up to one year and between one and two years hit lows of 32bp, 13bp and 18bp in December 2021, June 2021 and March 2021 respectively. Since then they have risen to 106bp, 194bp and 194bp respectively, levels not seen since early 2013.
Spread between rates on other NFC ST deposits and NFC ON deposits (ppt) (Source: ECB; CMMP)
The chart above illustrates the spread (opportunity cost) between NFC time deposits – again M2-M1- and NFC ON deposits over the past twenty years. In this case the opportunity costs of holding term deposits hit lows of -33bp in November 2021 for maturities up to one year and 4bp for maturities between one and two years. Since, then they have risen to 215bp and 243bp respectively, levels last seen during the GFC.
Growth rates (% YoY) in M1 and M2-M1 since 1999 (Source: ECB; CMMP)
ECB policy has triggered a reallocation of funds from overnight deposits to other ST deposits. The growth rate in M2-M1 rose to 21% YoY in April. This is, in turn, the fastest rate of growth since the creation of the EMU.
Monthly flows (EUR bn) on EA monetary aggregates (Source: ECB; CMMP)
Inflows into other ST liabilities, M2-M1 and, to a lesser extent, M3-M2 have been important but still insufficient to compensate fully for the outflows in overnight deposits (see chart above). Hence, monthly flows of M3 have been negative in six of the past seven months.
Problems with the panic narrative – “portfolio rebalancing”
The second problem with the panic narrative is that it ignores portfolio rebalancing to other financial instruments. Note that money supply is derived from the banks’ ST liabilities and does not include longer-term liabilities since they are not close substitutes for money.
According to the ECB, bank bond issuance has increased by almost €170bn since September 2022. The terms and conditions of TLRTO II were recalibrated at this point resulting in sizeable repayments of funds borrowed under the programme and an increase in (more expensive) bond issuance. Bond issuance was close to total c€200bn decrease in the bank deposits over the period.
In short, M1 dynamics reflect both a substitution of ON deposits with time deposits (opportunity cost) and shifts to bank bonds (portfolio rebalancing) and, to a lesser extent money market fund shares. Funding costs may be rising but there is no evidence of liquidity-driven panic.
Problems with the panic narrative – “causal links in money creation”
The final problem with the panic narrative is that it misrepresents the causal links in money creation. Contrary to what is often taught (“loanable funds theory”), banks are not intermediaries that take in deposits first and then lend them out. Instead banks create money.
“Whenever a bank makes a loan, it simultaneously creates a matching deposit in the borrower’s bank account, thereby creating new money”
(Bank of England, 2014).
Growth rates in (adjusted) private sector credit (% YoY) since 2003 (Source: ECB; CMMP)
The principal way in which bank deposits are created is through commercial banks making loans. Growth in private sector lending peaked in September 2022 at 7% YoY, however (see graph above). In April 2023, growth has slowed to 3.3% YoY from 3.9% YoY in March 2023 and 4.3% YoY in February 2023. The moderation in bank lending reflects the relatively rapid pass through from policy rates to the cost of borrowing, weaker demand and tighter credit standards.
Growth rates in M3, M1 and private sector credit (% YoY) (Source: ECB; CMMP)
Conclusion – focus on the wider message not the panic narrative
In short, recent EA monetary dynamics are unprecedented in some areas. They are not a cause for panic over EA banks, however. They reflect instead a combination of an increase in the opportunity cost of holding money, portfolio rebalancing, weaker credit demand and tighter credit standards.
This is not to suggest that the message from EA banks is a positive one. On the contrary, it remains one of weaker economic activity and a challenging policy context in which the ECB is expected to continue tightening as economic stresses mount. An important message, but a very different one to the “bank panic narratives” seen elsewhere…
Please note that the summary comments and charts above are abstracts from more detailed analysis that is available separately.
A tempting question to ask, but also the wrong one!
The key chart
Twenty-year trends in debt ratios (% GDP) broken down by type (Source: BIS; CMMP)
The key message
Denmark and the US are the only two, advanced economies that maintain absolute limits on the level of government debt. Interestingly, their public debt ratios (as opposed to debt levels) were essentially the same twenty years ago (54-55% GDP). Today, however, Denmark has the third lowest public debt ratio in the world (30% GDP), while the US has the seventh highest (103% GDP).
Unsurprisingly perhaps, while we hear little “political noise” about the Danish debt ceiling (or debt ratio), we are subjected to an overdose from the US. This leads some to ask, “Why can’t the US be more like Denmark”.
A tempting question to ask, but also the wrong one…
To understand why, we need to adopt a systemic view of the Danish and US financial systems that incorporates both public and private sector debt and reflects the reality of modern money creation.
Put simply, money creation relies on actions that add to bank deposits. Bank lending and government DEFICITS (despite what is taught in many textbooks) qualify, but in different ways. The repayment of bank loans and government SURPLUSES have the opposite effect – they destroy money.
In this context, a better question to ask is, “How do the processes of money creation in Denmark and the US differ and why does this matter?”
Total debt ratios have increased in both economies over the past two decades (see key chart above). In Denmark from 223% GDP to 246% GDP. In the US from 198% GDP to 256% GDP. The processes have been very different, however.
Denmark has effectively substituted government deficits and public debt (an asset of the non-government sector) with more private debt (a liability of the non-government sector) over the past two decades. In contrast, the US has substituted private debt – mainly household debt – with more public debt. In the process, the ratio of the stock of private debt (largely ignored by policy makers and economists) to public debt has risen from 3.2x to 7.2x in Denmark over the period. In the US, it has fallen from 2.6x to 1.5x.
The key point here it that private sector money creation faces unique supply (capital and regulation) and demand (ability of currency users to service debt) constraints. Despite more than a decade of HH sector deleveraging, for example, Denmark’s HH and NFC debt ratios remain above the levels where debt is considered a constraint on future growth. The result? Further private sector deleveraging, led by the HH sector.
Private sector models are also inherently less flexible, less stable and, in advanced economies, more prone to periods of crisis that require greater to levels of public debt to resolve/address.
While lending to the private sector is also the main source of money creation in the US, the government plays a much greater role than in Denmark. As a currency issuer, the US government does not face the same constraints as the private sector (although it does face other constraints). The US is also one of only three advanced economies where both HH and NFC debt ratios are below their respective threshold limits. In short, the structure of the US model provides more flexibility and more stability, as the response to the COVID-pandemic illustrated, and reduces the risk of crisis.
The US generates significantly more political noise about the management of government debt than Denmark, the only other country to maintain an absolute debt ceiling. This noise differential in not an accurate reflection of the relative strengths of the money creation processes in each economy. It is instead, a reflection of flawed macro thinking. Thinking that views public sector debt as a problem but largely ignores private debt and falsely equates the financial constraints of currency users and currency issuers.
The irony here is that a more accurate, systemic view of Danish and US money creations leads to a different question altogether – “Shouldn’t Denmark be more like the US?”
Why can’t the US be more like Denmark?
Twenty-year trends in public sector debt ratios (% GDP) (Source: BIS; CMMP)
Denmark and the US are the only two, advanced economies that maintain absolute limits on the level of government debt. Their public debt ratios (as opposed to debt levels) were essentially the same twenty years ago (54% and 55% GDP respectively, see graph above). Today, however, Denmark has the third lowest public debt ratio in the world (30% GDP, see graph below), while the US has the seventh highest (103% GDP).
BIS reporting nations ranked by 3Q22 public debt ratios (% GDP) (Source: BIS; CMMP)
Unsurprisingly, while we hear little political noise about the Danish debt ceiling (or debt ratio), we are subjected to an overdose of “political noise” from the US. This leads some to ask, “Why can’t the US be more like Denmark”. A tempting question to ask, but also the wrong one…
Money creation in Denmark and the US – a systemic view
To understand why, we need to adopt a systemic view of the Danish and US financial systems that incorporates both public and private sector debt and reflects the reality of modern money creation.
Money creation relies on actions that add to bank deposits, the main form of money today. Bank lending and government deficits (despite what is taught in many textbooks) qualify, but in different ways. The repayment of bank loans and government surpluses have the opposite effect – they destroy money.
In this context, a better question to ask is, “How do the processes of money creation in Denmark and the US differ and why does this matter?”
The changing nature of money creation – total debt broken down by type (% total debt) (Source: BIS; CMMP)
The graph above illustrates how Denmark has effectively substituted public debt (an asset of the non-government sector) with more private debt (a liability of the non-government sector) over the past two decades. In contrast, the US has substituted private debt – mainly household debt – with more public debt.
Note the relative scale of the stock of private sector debt (largely ignored by policy makers and economist) in relation to the stock of public sector debt over the period (see graph above). In Denmark, the ratio rose from 3.3x to almost 10x before the GFC, fell back and then rose again to 7.2x today. Again, in contrast, the US ratio has fallen from 2.6x to 1.5x over the period.
Twenty-year trends in Danish money creation (debt as % GDP) (Source: BIS; CMMP)
In other words, lending to the private sector is a far more important source of money creation in Denmark (see graph above) than in the US (see below). As an aside, the Danish government ran a budget surplus in 2022, destroying money in the process.
The key point here it that private sector money creation faces unique supply (capital and regulation) and demand (ability of currency users to service debt) constraints. Despite more than a decade of HH sector deleveraging, for example, Denmark’s HH and NFC debt ratios remain above the level where debt is considered a constraint on future growth (see graph below). For reference, the BIS considers that HH and NFC debt ratio of 85% GDP and 90% GDP represent threshold limits above which debt becomes a constraint on future growth.
HH debt ratios plotted against NFC debt ratios for selected BIS reporting nations – red lines represent BIS threshold limits (Source: BIS; CMMP)
The result? Further private sector deleveraging, led by the HH sector (see chart below). Note also that private sector models are also inherently less flexible, less stable and, in advanced economies, more prone to periods of crisis that require greater to levels of public debt to resolve/address.
Twenty-year trends in US and Danish HH and NFC debt ratios (% GDP) (Source: BIS; CMMP)
While lending to the private sector is also the main source of money creation in the US, the government plays a much greater role than in Denmark (see chart below). As a currency issuer, the US government does not face the same constraints as the private sector (although it does face other constraints). The US is also one of only three advanced economies where both HH and NFC debt ratios are below their respective threshold limits.
In short, the structure of the US model provides more flexibility and more stability, as the response to the COVID-pandemic illustrated, and reduces the risk of crisis.
Twenty-year trends in US money creation (debt as % GDP) (Source: BIS; CMMP)
Conclusion – shouldn’t Denmark be more like the US?
The US generates significantly more political noise about the management of government debt than Denmark, the only other country to maintain an absolute debt ceiling. This noise differential in not an accurate reflection of the relative strengths of the money creation processes in each economy. It is instead, a reflection of flawed macro thinking. Thinking that views public sector debt as a problem but largely ignores private debt and falsely equates the financial constraints of currency users and currency issuers.
The irony here is that a more accurate, systemic view of Danish and US money creation leads to a different question altogether – “Shouldn’t Denmark be more like the US?”
Please note that the summary comments and charts above are abstracts from more detailed analysis that is available separately.
