Allow me to begin, as usual, by thanking the organizers, sponsors, and the Men\u00e9ndez Pelayo International University for their kind invitation. As you know, the presence of the AEB President has been customary at this forum for decades, and while it would be an exaggeration to describe this annual appointment as pleasurable, I can say that it is a custom I am beginning to embrace with the mixture of concern, anticipation, and tension associated with important engagements. <\/p>\n
You are aware of my tendency toward structural matters, whether in terms of medium-term evolution or structural characteristics of the present that we often overlook. I fully understand that news is about current events, so my words sometimes do not facilitate your immediate work, but they can, I say this with all modesty, contribute to understanding that very lively, complex, and elusive reality. In my defense, I can only say that my past as a research department economist conditions me more than I would like. <\/p>\n
This year I want to discuss a highly topical subject, a situation so exceptional that it could disappear at any moment, even in the weeks that will elapse between the writing of these lines and their reading in Santander. I am referring to the ultra-low interest rate environment we are experiencing. And calling them low is even an exaggeration, because we are actually witnessing episodes of negative rates, which in itself constitutes a contradiction, because in what economic logic does it make sense to pay to lend and receive payment for borrowing. A situation that, moreover, is tremendously addictive for markets and governments, and that places central banks in a complex position, as they end up being the support for the entire economy. What is called a goldilocks economy consists of a combination of ultra-loose monetary policies, an economy and financial system with very abundant liquidity, and positive growth expectations driven precisely by those expansionary factors. But it also conceals notable fragility, insofar as both an acceleration in rate increases and an excessively prolonged maintenance of the low-rate environment (and the consequent negative effects this would entail) would destroy that happy Arcadia we have artificially created. If, in general, soft landings are a chimera, in this case they may be even more so, as I very much fear that the normalization of rates will not occur without negative effects. There is a reason we have gone from talking about the taper tantrum to the supertaper tantrum and, lately, the triple taper tantrum (simultaneous rate increases in the US, Japan, and the eurozone). <\/p>\n
Over the next few minutes I will attempt to outline some of the foreseeable consequences of this paradoxical environment, but not before explaining, or at least attempting to, why we have reached this point. My concern is certainly neither novel nor unique. Figures as prominent as Larry Fink, Chairman of BlackRock, have stated that central banks, through their actions on interest rates, are “destroying value” (we are destroying the value of pension funds\u2026 we are destroying the viability of insurance companies). <\/p>\n
The international crisis we have experienced, the so-called Great Recession, has not only caused a considerable loss of wealth and GDP, but has also put economic policymakers around the world against the ropes. The Spanish economy, for example, despite the strong recovery process it is experiencing, will not recover its pre-crisis GDP level until 2017, while public debt has risen from 37% of GDP to over 100%, and unemployment, especially youth unemployment, remains at socially unacceptable rates. <\/p>\n
It is true that the Great Depression has been avoided, and this is no small matter, given the destructive effects that devastating crisis had on the world population. And when we speak of these effects, we refer, among other things, to the pernicious deflationary cycle that destroyed the productive fabric of the interwar period. Deflation, understood as the potential risk of a prolonged decline in prices, can cause multiple difficulties. First, it is a symptom of weak aggregate demand, which can also reinforce depressive expectations in the economy (insofar as consumers postpone the purchase of goods and services in anticipation of price reductions). Second, in the presence of rigid nominal wages, it can worsen unemployment and increase, once again, the depressive tendencies of the economy. Third, it greatly hinders deleveraging processes, since the mere passage of time increases real debt. This element, in the current context of high public and private debt in the eurozone and Spain, is particularly concerning. <\/p>\n
It is not the purpose of this presentation to review the measures taken, either by the Fed or by the ECB, to avoid the dangers of a persistent deflationary process. In the case of the ECB, these measures include not only a reduction in interest rates, but a series of expansionary and unconventional monetary policy measures ranging from TLTROs (Targeted Longer-Term Refinancing Operations) to OMT (Outright Monetary Transactions, not yet implemented), including an aggressive Asset Purchase Program (LSAP, or Large Scale Asset Purchase). These were and are necessary measures to avoid the potential dangers associated with a potential deflationary spiral. We do not align ourselves, therefore, with the view that periods of deflation in the past have been relatively frequent and did not consistently cause losses of output and wealth. On the contrary, the mere risk of entering a deflationary spiral justifies the measures taken in itself. <\/p>\n
This does not prevent us from reflecting on the collateral and unintended effects that this prolonged period of extremely low interest rates may have. This crisis has been and is complex, as well as prolonged, and this aspect we are addressing today is but one more of those complexities of the crisis experienced. <\/p>\n
The real interest rate (obtained when we discount expected inflation from the nominal rate) is the price at which current consumption opportunities are exchanged for future ones, that is, the remuneration the consumer receives for forgoing present consumption and saving to consume in the future (it is the intertemporal discount rate). If that rate is zero, or even negative, we are encouraging the consumer to stop saving and encouraging them to make consumption decisions now that should be postponed for the future. <\/p>\n
A decline in inflation faster than the decline in nominal rates entails a potential increase in real rates if inflation expectations become unanchored and that decline is expected to continue. When entering a deflationary spiral, it tends to accelerate, especially if it encounters rigidities in nominal interest rates, since these, in principle, cannot fall below zero and at those levels lose their effectiveness as an instrument to drive monetary policy easing. A situation similar to that described explains the authorities’ decision to resort to so-called unconventional monetary policy measures. <\/p>\n
But let us think about the medium-term savings needs of economies and use, as an example, an economy like Spain’s, while acknowledging that the conclusions reached should not be applied exclusively to it.<\/p>\n
And this is because Spain is a country that exhibits two characteristics. On the one hand, like other mature economies, it shows an aging population that will increase future pension expenditures. This will result in a larger public deficit and increase in the stock of public debt, or a reduction in public benefits, with the consequent need to increase private savings so that public benefits can be supplemented. On the other hand, it shows a level of external debt (or a negative net international investment position) very high in relation to both GDP and that prevailing in other countries in our environment. If we want to avoid risks in terms of financial fragility (refinancing problems generated by internal or external shocks), we must reduce that external debt, which requires saving as a nation. In short, the Spanish economy must consume less (and hopefully not invest less) and strengthen either private or public savings, or both, to meet the challenges of population aging and reduce our substantial external debt. <\/p>\n
Thus, the paradox arises from the incentive to consumption (and investment, it is true) represented by current ultra-low interest rates. Let us say that in the medium term we must reach a destination of less consumption and more national, public, and private savings, although in the short term we have taken a detour that temporarily distances us\u2014or so I trust\u2014from that objective. <\/p>\n
This paradox is more intense in the Spanish economy than in others in our environment, mainly due to our high external debt. But we must remember that another element, that associated with population aging, is common to all Western countries. <\/p>\n
It is undeniable that this exceptional interest rate environment will not be sustainable for long, as ultimately the ultra-expansionary monetary policies can be expected to impact inflation expectations, that is, demonstrate their effectiveness. But it is also true that the experience of those countries that are more advanced in this process (the US, specifically) shows us that the normalization of monetary policy, the increase in intervention rates and their transmission to medium- and long-term market interest rates, is a delicate process, with poorly controlled impacts, whose materialization will take time. Therefore, agents know that, while interest rate increases are on the horizon, there are still many uncertainties regarding the moment at which they will be undertaken and the intensity (or speed, if you will) of that increase, or regarding their impact on the yield curve at different maturities. <\/p>\n
That low interest rate environment generates, on the other hand, an inevitable search for yield process in all segments and financial products, and an undeniable relaxation of the standards normally applied to investment analysis. This is particularly true in shadow banking segment operations. Thus, focusing on the financing of larger companies, cov-lite financing operations abound, that is, with relaxation of the covenants or conditions imposed on borrowers to ensure that they, if necessary, will make the necessary adjustments in their business strategy to guarantee loan repayment. In short, covenants seek to avoid deterioration in risk over the life of the loan (usually medium or long term), establishing conditions such as: <\/p>\n
\u2022 limits on dividend distribution,
\n\u2022 limits on debt operations without prior approval,
\n\u2022 limits on changes in management or mergers without prior approval, and
\n\u2022 leverage limits.<\/p>\n
Another sign of relaxation of standards is the greater abundance of bullet loans, that is, loans in which the principal, and even interest, are paid in a single lump-sum payment at the end of the period. It is evident that risk management is more complex in this type of loan, when compared with the classic financing structure, with regular amortization and interest payments, which entails a reduction in risk through the mere passage of time. <\/p>\n
But probably the most evident sign to illustrate the relaxation of standards is that of the interest rates themselves charged in these operations, which, as I have had occasion to mention in other interventions, do not adequately cover the risk, and therefore will hardly yield positive returns. Faced with these trends, driven by shadow banking, one can only exercise extreme caution and not be carried away by the siren songs of very complex market conditions: if the profitability of a credit operation cannot be guaranteed, it is better not to enter into it. <\/p>\n
As I said, it is no coincidence that many of these cov-lite operations with low rates come from the shadow banking segment. On the one hand, these types of activities face much better regulatory conditions than banks, subject to a strict new regulatory and supervisory regime. On the other hand, the pressure of the search for yield for these entities can be very great (for example, some insurance companies may be tempted to enter the corporate financing market to cover the yield offered in their products). In any case, it is another example of the dangers to financial stability represented by developments in this sector, not only in the medium, but also in the short term. <\/p>\n
This type of operation also complicates the future normalization of interest rates. Indeed, a sudden reversal of rates could cause devastating effects given the financial fragility caused by this relaxation of standards. But, conversely, if fear of the contagion effects of a rate increase leads to a slower normalization of the yield curve, the persistence over time of low rates will further complicate the situation (with more search for yield and more relaxation of credit standards). As I have already commented at the beginning of my presentation, this goldilocks economy, that interdependence between buoyant markets and monetary policy, seems destined for an ending that, if not tragic, will be unhappy. And, without entering into matters that do not concern me, I believe that the lessons of this excessive dependence of central banks on markets (that fear of disappointing markets) will endure over time, albeit with consequences that, as of today, we cannot glimpse. <\/p>\n
Central banks insist that, to avoid these pernicious effects, both microprudential and macroprudential measures must be adopted. But while taking such measures is possible for sectors such as banking, for other financial sectors it is more complex, if not impossible: we have neither the data and analytical tools necessary to assess risks in those sectors, nor legal instruments to act in the event that fragilities are identified. Perhaps in the future, with new regulatory and institutional developments, this will be the case, but it certainly is not at the present time. And this despite the regulatory tsunami that this financial crisis has caused. <\/p>\n
If the situation of very low interest rates entails evident dangers from the point of view of professional market operators, it is no less true that the problems may be even greater for the consumer. You have heard me on other occasions, and specifically on the occasion of the presentation of initiatives in financial education, mention the need to convey to consumers the general idea that higher returns mean higher risk. Well, in the current circumstances of lower interest rates, we could refine the message by noting that, as of today, any positive market return entails risk. <\/p>\n
Let us not deceive ourselves, the combination of financial illusion, lack of knowledge in the matter, and the search for returns like those of the past that, as of today, are not achievable without assuming much more risk, can lead to spurious demand for complex products. Therefore, from the sector we must exercise extreme due diligence to protect the genuine interest of our clients. <\/p>\n
When I refer to financial illusion I mean that our perception of the profitability of financial products is distorted, since for most of us a period of deflation like this is a genuine novelty in our lives and experiences. Indeed, with price declines of 1%, a financial product with zero return offers a real return of 1%, that is, a not inconsiderable return. Just as in times of higher inflation, now fortunately forgotten, high nominal returns concealed negative real returns, now the opposite occurs. <\/p>\n
The ultra-loose monetary policy is, without doubt, a lesser evil that avoids the scenario of unanchored inflation and economic growth expectations and prevents the potential appearance of a deflationary spiral. It is the price to pay, or rather, the insurance that guarantees that the Great Recession will not become the Great Depression. Having said that, in addition to introducing the complexities already mentioned, low interest rates severely affect the profitability of financial institutions. For illustrative purposes, we will focus on banks, insurance companies, and pension funds. <\/p>\n
The banking business is, in principle, simple: lend long-term to the non-financial sector (the real economy), financing itself with borrowed resources (in a leveraged manner) obtained at shorter maturities (and, therefore, at lower cost). This is the well-known maturity transformation process of banking, which differentiates it from other financial sectors and is of vital importance in the economic ecosystem. To this maturity transformation element we must add another defining element, financing via bank deposits, not only term but also demand deposits (which are traditionally associated with transactional banking and short-term client operations). <\/p>\n
The current situation of low interest rates (Chart 1 and Chart 2) affects banks in two not entirely independent ways. First, insofar as clients’ transactional deposits\u2014a not inconsiderable part of liabilities\u2014usually have low, if not zero, remuneration, the higher the interest rate, the greater the interest margin: the difference between asset rates (those charged on loans) and liability rates (the cost of financing) is greater, since only part of the liabilities see their cost increased. When rates fall, the margin contracts, and when they are close to zero, the advantage of having a significant source of cost-free liabilities almost disappears. Second, rate declines, especially of the intensity experienced in the last year, flatten the yield curve, that is, the difference between long-term and short-term rates largely disappears (Chart 3). Since a fundamental part of the banking business, maturity transformation (financing credit with shorter-term liabilities), has no value when the curve flattens, this negatively affects profits. If this process were prolonged over time, it could jeopardize the financing of the economy, since unprofitable banks cannot adequately finance their clients. As I will point out later, Spanish banks are, fortunately, in a better position in this regard. <\/p>\n
In the case of insurance companies (Charts 4 and 5), the effect comes mainly from assets. All of them must obtain a sufficient return on their portfolio to cover insured contingencies. A decline in rates may entail insufficient profitability to meet claims (although things are more complex: in automobile insurance, rate declines associated with economic slowdown usually entail a decrease in claims due to reduced use of transportation). In the case of savings-insurance products, a distinction must be made between defined contribution products, in which the policyholder bears the financial risk, and defined benefit products, where the opposite occurs, with the insurance company assuming the financial risk. For the latter, a decline in interest rates would cause losses for the insured company (unless it has perfectly matched its liabilities, its commitments to the policyholder, with financial assets at the same maturity and at least the same return as that offered). <\/p>\n
Something very similar happens with pension funds. If they are defined contribution, the financial risk falls on the participant, who, if necessary, must increase contributions to guarantee the desired income level after retirement. But if they are defined benefit, the risk is assumed by the sponsor, and if maturity coverage is not perfect (which is usual), the decline in rates will cause a pension fund deficit that, eventually, must be covered by the sponsor of the defined benefit pension fund. <\/p>\n
What happens in Spain? For once, these impacts, although they exist, are more limited than in other countries. Starting with pension funds, defined benefit funds have a very marginal importance, being limited, in the case of occupational funds, to schemes already closed in the past and that do not usually affect the entire workforce (but rather an increasingly marginal part of it). As for insurance products with guaranteed returns, again, in the Spanish case, they have very limited importance due to the traditional prudence of Spanish insurers (see Chart 4). Regarding the impact of the rate decline and the flattening of the curve (see, again, Chart 3), these effects are smaller in Spain and both the level of rates (due to the risk premium) and the yield curve (which has a steeper slope than that of core eurozone countries) are more favorable, although it cannot be said that their evolution does not impact the profitability of banks or insurance companies, they simply do so to a lesser extent. <\/p>\n
The measures by central banks aimed at avoiding the risks of a potential deflationary spiral are probably appropriate and should be supported. This does not prevent us from being aware of the unintended effects of such a prolonged period of low interest rates on financial stability and on the profitability of financial intermediaries. And we must also be aware that this exceptional period will either end abruptly, with rate increases faster than expected, or will be prolonged over time, which will only exacerbate the contradictions between economic growth, financial stability, and solvent financial intermediaries. It is therefore necessary to avoid both situations and seek together a way to redirect this situation toward a normalized path of interest rates, consistent with the real expectations of our economies. <\/p>\n
Thank you very much.<\/p>\n