This is the second article in a two-part series where BusinessNow.mt interviews Maltese financial thought leaders about central banks’ decision to bring a decade of easy access to finance to a close. Read the first part here.
When the European Central Bank (ECB) announced in early June that it would be increasing interest rates and stopping its Asset Purchase Programme (APP), it did so in the hope of easing inflationary pressure to give households and businesses a chance to keep up with rising costs.
By now, everyone will have noticed the sharp increase in the price of many items, as inflation hits highs unseen in decades, raising the spectre of an inflationary spiral. However, how much of this is due to the trillions of euros and dollars pumped into the economic system, and how much of it is the result of supply chain issues caused by COVID-19 restrictions and the war in Ukraine?
BusinessNow.mt reached out to some of Malta’s top economic minds to see why prices are rising, and what central banks’ efforts to bring them under control could mean for the European and Maltese economies.
Causes of inflation
Jesmond Mizzi Financial Advisors executive director Mark Azzopardi describes inflation as the “key factor” behind central banks’ decision to adopt contractionary monetary policy (where the supply of money is tightened by making it more expensive to borrow – the opposite of quantitative easing (QE)). “Central banks are realising that inflation may be less transitory than expected.”
He says that part of the increase in prices could be attributed to the financial stimulus issued in response to COVID, especially in the USA, which, together with increased savings, pushed up demand.
More pertinent factors, however, Dr Azzopardi argues, are “the severity of China’s Zero COVID policy, which continually seems to be locking down huge swathes of its population”, leading to complications in its manufacturing sector as well as in shipping, and the Russian invasion of Ukraine together with the subsequent sanctions imposed by Western countries on Russia.
Since Russian commodities, ironically enough, include those required for Europe’s energy transition, which is speeding up to reduce dependency on Russian oil and gas, he says “it is possible that the issues surrounding the invasion will continue as the world progresses through 2022”.
Clint Flores, executive head on environmental, social and governance affairs (ESG) at Bank of Valletta and formerly a political and security committee ambassador with Malta’s Permanent Representation to the European Union agrees that political instability is having an outsized effect on prices.
“Sanctions are changing by the hour, so economic operators are adopting an over-compliance and over-due diligence approach to avoid breaking any imposition of sanctions. This is stifling imports from and exports to Russia.”
He says that economic and political actors need to see how monetary policy, in “such a difficult scenario” would work, and also highlights the appreciation of the euro versus other currencies, “which would be a determinant factor in decreasing inflation in the medium to long term”.
Mr Flores continues: “Unless supply of basic commodities is increased, inflation will take time to subdue, and monetary policy would need to be complemented with elements of fiscal policy for those countries in the eurozone that can sustain it. Certainly, controlling inflation is a must.”
Jordan Portelli, chief investment officer at Calamatta Cuschieri, sums up the situation as a struggle between the disruptions and geopolitical tensions pushing prices upwards and the efforts of central banks to keep them under control. However, he warns that the end of QE means that a key tool in the anti-inflation arsenal has been removed just as the global economy faces remarkable uncertainty.
Is recession on the way?
Mr Portelli wonders whether this perfect storm of issues could ultimately push the global economy into a recession, or simply a period of lower growth.
“We all hope for the former which should help in managing future economic prospects. If the latter happens, we still believe that it will be a softer recession when compared to the last recession back in 2009.”
Matthias Busuttil, head of investment strategy and research at Curmi & Partners, is also sceptical of a deep downturn: “Whilst many argue that the tightening of monetary conditions will likely lead to a recession, I find it to be less plausible. The risk is there, especially in the event of a policy misstep, but it is avoidable. The initial conditions of the global economy are stronger than in previous crises. Household balance sheets are stronger, private and public debt levels are broadly lower (even though these have gone up since 2020 given the pandemic) and the recapitalisation of banks post the 2008 crisis puts them in a far stronger position today.”
Mr Busuttil says that all these improvements reduce the likelihood of a structural crisis triggered by a build-up in risk taking which, in turn, limits the scope of a deep contraction and a long duration for recovery.
“We are already seeing a number of fiscal initiatives (including the Next Generation EU and RePower EU) to support weak parts of the economy as monetary policy support is gradually withdrawn. This policy handover is crucial to avoid a fatal blow to economic conditions.” He also points to high levels of household savings, expected to support spending, at least in the beginning, as real disposable income is eroded by the high inflation. “Vacancies and hiring intentions remain relatively strong which should also cushion the potential adverse impact on unemployment levels.”
These conditions, Mr Busuttil believes, give central banks some leeway, albeit very limited, to tighten monetary policy and bring inflation back towards more normal levels whilst limiting the adverse impact on economic activity and labour markets: “Policy coordination and credibility are key in maximising the probability of the desired response and economic outcome.”
So what, exactly, are central banks doing to control inflation? Essentially, the exact opposite of quantitative easing – quantitative tightening (QT).
Dr Azzopardi explains: “During a QT cycle, central banks first stop buying government debt, then begin raising interest rates, and finally deploy QT, which means that they shrink the size of their government debt holdings, normally by a process known as running off the balance sheet, which means instead of buying more government debt with the money they receive as their treasuries mature, they take that money and simply destroy it, taking it out of the system.”
What QT does, Dr Azzopardi continues, is that it takes government debt away from central banks and puts it once more in the hands of investors with a profit motive. This implies that the yields on government debt would have to substantially increase, making them far more enticing investments.
“If you can lend to the US government and receive three per cent per annum with virtually no risk taken, then in order to take on the risk of, for example, equities, their yield must go up substantially. In order to increase the yield you must decrease the price, and that is arguably a big part of the reason we are seeing equity (and all other asset classes for that matter) tumble in price. Valuations go down as the risk-free rate increases.”
The idea behind QT is that it rebalances the calculation investors make when choosing where to put their moey, by making leaving money in the bank more profitable. On the other hand, since governments, companies and consumers are forced to offer creditors higher interest rates to tempt them to lend them money, demand for credit should decrease, reducing the supply of money by reducing the demand for it in a process known as demand destruction.
This phenomenon is perhaps most easily observed in the real estate market, since property prices are highly sensitive to the amounts buyers are willing to pay. The low interest rates in effect over the last years meant that buyers could take on larger loans, leading property prices to increase. However, as interest rates rise, the cost of a mortgage increases, and thus the affordability of property suffers.
As investment and consumption slow down, so does economic growth, which has a knock-on effect on labour markets, with a rise in unemployment easing wage pressures, further bringing down inflation.
Impact on financial markets
With bond issuers no longer guaranteed steady demand, the interest rates offered need to increase – and they already have, significantly. Mr Busuttil says there has been a notable rise in bond yields, with US 10-year Treasury yields rising from 1.51 per cent since the start of the year to 3.27 per cent, while German 10-year Bund yields rose from -0.18 per cent to 1.77 per cent (as at 21st June 2022).
He continues: “Secondly, the reduction of monetary support is contributing, along with inflation and growth concerns, in the widening of sovereign spreads and corporate bond spreads – in other words, the increment yield over the highest quality bonds (benchmark bonds) that is offered on bonds issued by other governments (in the case of the Euro Area) and by corporates. Such conditions mean that raising capital will be more challenging and certainly more expensive.”
Impact on the euro
Malcolm Bray, senior manager in data insights and economics at BOV, highlights the risks the current conditions pose to the Eurozone: “As yields on sovereign bonds started to rise, the risk of financial fragmentation in the euro area became relevant again. Should investors shy away from the weaker issuers, the spread among euro area sovereign bond yields could increase, as the shield offered by quantitative easing is no longer in place.”
Dr Azzopardi elaborates: “The risk of a sovereign, like Italy, is measured by comparing the spread (difference in one interest rate and another) of interest on German government debt to the interest paid on Italian debt. If this grows too large, there would be concerns about financial stability within the Eurozone.”
Mr Bray notes that the ECB has already started working on the design of a new anti-fragmentation instrument to protect against such risks. “This should reduce any concern of another sovereign debt crisis in the euro area in a post quantitative easing world,” he says.
Effect on Malta
“Malta, to a certain extent, was insulated from an economic point of view way back in the last recession,” says Mr Portelli. “This time round the situation is slightly different,” pointing to the steep increases seen in the price of food and its “inevitable” effect on disposable incomes and therefore consumption.
He believes the removal of QE, combined with the premediated higher interest rates and the current geopolitical tensions, will have a negative impact on the Maltese economy. “Moving forward, financing conditions will be tighter, and thus the Government might need to support selected sectors which have been historically the backbone of the Maltese economy. This is a very particular situation with prudence being imperative, as bad decisions can literally swing the economy from a soft landing to unwanted territory.”
Mr Flores sees the current situation affecting Malta largely indirectly, with a reduction in demand in larger economies affecting exports of goods and services. However, the domestic demand is also likely to see a contraction, with people possibly resorting to saving money to make up for the increase in prices, at least until the arrival of a cost-of living adjustment to wages, or to prepare for any unexpected problems caused by the same instability. Similarly, investors may opt to limit their investments to keep liquidity to speculate to make a profit or to take advantage of cheaper commodities.
Mr Busuttil meanwhile notes that yields on Malta Government Bonds have soared since the start of the year, while prices have dropped significantly. The impact on the local corporate bonds market and equity market has been more muted, “largely reflective of the very low liquidity, or trading activity, which limits the price discovery mechanism of a public market, but also due to the large ‘buy-to-hold’-type investor base which reduces market volatility.”
However, although limited, the impact is not immaterial, with selling pressure and a general decline in corporate bond prices observed as of late. “This presents a challenge to new primary market transactions being considered by local issuers since they may very well need to price their bond or equity listing at more attractive terms to raise the interest required from investors.”
Mr Busuttil expects the interest rates offered on bank deposits to rise too, in line with those offered by other banks across Europe. He believes the local banks will probably “be able to shield local borrowers from an abrupt increase in loan rates given the loan pricing dynamics locally and the large and sticky depositor base”, although “with a general rise in interest rates globally, local lending rates will eventually follow.”
As a small open economy which is highly dependent on external trade and investment, a protracted decline in global economic activity will undoubtedly affect the local economy negatively, continues Mr Busuttil.
“We are already witnessing the increase in prices in food, durable goods and services. Having said that, Malta has proven its ability to remain competitive and weather periods of global turmoil comparatively better than peer economies in the past. Strong stewardship of public finances and fiscal initiatives will be crucial to carry the economy and preserve the well-being of citizens and businesses alike through this challenging period.”
Mr Bray agrees: “Businesses and households need to update both their interest rate and growth outlook, taking on board the end of quantitive easing, the announcement by the ECB of future rate increases, and the slower international growth prospects due to the tightening of monetary policy.”
“There are challenging times are ahead,” he concludes, “but the Maltese economy has exhibited remarkable resilience time and time again.”
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