Interview with Helsingin Sanomat

Interview with Luis de Guindos, Vice-President of the ECB, conducted by Petri Sajari

26 November 2024

What are the main risks to financial stability in the euro area, and how could those risks materialise?

To assess the risks, we first need to look at the wider macroeconomic outlook. On the one hand, inflation is declining and will return to our medium-term target of 2% in 2025. But on the other hand, economic growth is very weak. According to the European Commission’s Autumn Forecast published last week, growth in the euro area will be below 1% this year, very much in line with our September projections, with risks tilted to the downside. We will have new projections in December, but developments point to growth remaining fragile. So concerns about high inflation have shifted to economic growth. On top of that, geopolitical risks are increasing and uncertainty about US policy could affect trade and fiscal policy, with broader implications for the euro area economy.

In this context, we see three key areas of concern for financial stability. First, high risky asset valuations and risk concentration in financial markets. For instance, a few stocks in the United States – those of the Magnificent Seven – make up a very large proportion of US equity market capitalisation. At the same time, a large and increasing share of US securities are held by euro area non-banks. In the event of a correction, this could lead to broader problems for the entire financial system. Second, sovereign debt levels are high in an environment of very low growth, and some countries have public debt ratios above 100%, raising concerns about fiscal sustainability. And finally, there are some pockets of vulnerability in the corporate sector, where we may see an increase in insolvencies. Households, however, have increased their savings and reduced their debt while benefiting from a strong labour market, so their situation is positive so far. But this could change should growth turn out to be weaker than expected.

During the pandemic, countries in the euro area became even more indebted. Is this a threat to financial stability, especially if government bond yields rise even higher?

So far, the behaviour of the sovereign bond market has been quite positive – we haven’t seen a significant increase in yields and spreads are quite contained. However, markets are paying increasing attention to fiscal policy. The United States is a case in point: it has very high public debt and public deficit ratios, and government bond yields have increased. So markets have started to react and they might focus more on fiscal policy over time.

In Europe, it will be important to fully implement the new economic governance framework, including the rules for countries’ medium-term fiscal plans. This will help us deliver reasonably prudent fiscal consolidation while creating space for investment in projects tackling longer-term challenges like the digital transformation, climate change and defence. But we will need to square the circle, because it will be very difficult to reach these objectives of fiscal consolidation alongside investment in several key areas in an environment of low economic growth. That’s why it is so important to foster potential growth. It will depend on the implementation of structural reforms.

The euro area has become more indebted and countries need to increase their defence spending. Is there a risk of a new debt crisis?

Right now, markets are very calm. In terms of sovereign bond spreads, the situation is firmly under control. What we need to achieve now is a positive, medium-term balance between fiscal consolidation and space for investment in key areas, like defence. Countries don’t need to drastically reduce their fiscal deficits in the short term, but they do need to send a signal that over a seven-year horizon – the period included in the new fiscal framework – they will be able to reduce their primary deficits and public debt ratios, all while investing in key areas. And like I said earlier, strong economic growth will be a critical element for achieving this.

The latest Financial Stability Review talks at length about geopolitical risks, which have increased recently. To what extent might they affect financial stability in Europe? And how big of a threat are cybersecurity risks?

Cybersecurity is a very real threat, and it’s an important element of geopolitical risk. Cyberattacks are pervasive – they are something that we have to consider very carefully and be well-prepared for, especially in the current geopolitical context.

Beyond cybersecurity, the main sources of geopolitical risk for Europe right now are the conflict in the Middle East and Russia’s war against Ukraine. Markets aren’t very good at assessing geopolitical risk and tend to see things in black and white, but it’s something we need to take into consideration that will become even more important in the future. And on top of that, there are the potential changes in US trade policy, which will only add to the uncertainty created by geopolitical risk.

What about climate change? How could it affect financial stability?

Climate change can affect the outlook for growth and inflation, for example through its impact on food prices. This is something that we continuously assess as part of our price stability mandate. Aside from that, climate change makes natural disasters more frequent and severe, which has a negative impact on banks and the economy.

Take the recent floods in Spain, for example. Climate change and the warming of the Mediterranean is making the storms that have always been common at this time of year more violent and frequent than in the past. On top of the tragic human cost of more than 200 lives, the Banco de España estimates that the floods will cost the Spanish economy up to 0.2% of GDP in the fourth quarter of this year. These natural disasters can also affect financial stability through their impact on banks’ balance sheets: Spanish banks have exposures of around €20 billion to that part of the Mediterranean coast, through mortgages to households and loans to local companies. These floods are just one example of the implications of physical climate risk materialising for banks, insurers and the economy as a whole.

Here at the ECB, we assess the economic and financial impact of climate change and the green transition. We have also implemented concrete measures in our work, for example by “tilting” Eurosystem corporate bond reinvestments or greening our own portfolios wherever possible. But it is governments that should address climate change because they have the right tools at their disposal, such as fiscal policies and regulation.

Let’s move on to what’s happening in the United States. The next President, Donald Trump, has already announced that he will impose significant tariffs to protect domestic production. How would those affect the euro area economy and how should we prepare for such risks?

We don’t yet know exactly what policies will be implemented, so it’s difficult to make a definitive assessment of the potential impact on Europe. But it is clear that we would need to gauge not only the direct impact on European and non-European goods, but also the broader disruptions to trade flows that would happen as a result. When you impose tariffs, you need to be prepared for the other side to retaliate, which can start a vicious circle. Eventually, this could turn into a trade war, which would be extremely detrimental to the world economy. It would mainly hurt growth, but it would also have an indirect impact on inflation, and it could even have implications for financial stability. It would be a lose-lose situation for everyone.

Apart from the potential tariffs, we will also need to see how US fiscal policy evolves. By reducing taxes but maintaining public spending, fiscal policy becomes more expansionary, which, paired with a very high fiscal deficit and public debt ratio, could cause fiscal sustainability issues. The United States and the US dollar play a very important role in the world economy, but these developments could raise doubts in financial markets. As I said before, we have already seen an increase in bond yields, and bond vigilantes will make a comeback. These are all elements that we have to consider to assess the potential impact on Europe.

Some economists have already said that those tariffs would be very inflationary for the United States.

An increase in tariffs is a supply-side shock. First and foremost, the initial impact would surely affect growth, but there could also be an indirect impact on inflation. Afterwards, if this initial impact on inflation were accommodated by fiscal and monetary policy, it could become much more structural. So growth would be affected the most, and additional monetary and fiscal impulses could make the effect on inflation more permanent.

In the euro area, inflation has already fallen below the ECB’s target, but the economy is still very fragile – can we expect several interest rate cuts in the near future to safeguard economic growth?

We are confident that inflation will converge towards our target of 2% over the medium term, although we may see an uptick in headline inflation by the end of the year. A key element here will be services inflation, which currently stands at 4%. This is closely related to the evolution of wages and wage increases, which we expect to start slowing in the first half of 2025, and to inflation expectations, which have also been moderating. So if services inflation starts to decelerate, we believe that headline inflation will converge steadily towards target. Simultaneously, core inflation, which is now slightly above 2%, will also converge towards our target. We have cut interest rates three times and the trajectory of our monetary policy is clear – if our projections are confirmed, we will continue making our monetary policy stance less restrictive.

Markets currently predict that the deposit facility rate will be somewhere between 1.75% and 2% at the end of next year. Do you think that’s possible?

It will depend on the evolution of inflation. Faced with such huge uncertainty, it’s difficult to make predictions about the specific number and size of rate cuts, which is why the meeting-by-meeting and data-dependent approach is so important. But it is clear that we will keep making our monetary policy stance less restrictive, because inflation is getting closer to our target.

Your colleague, Fabio Panetta, said last week that the ECB should concentrate more on safeguarding economic growth now that inflation is under control. Do you agree with him?

Our mandate is price stability. Monetary policy can affect growth in the short term, but our focus is on inflation in the medium term. That being said, to achieve price stability, we consider the evolution of the wider economy and of domestic demand. Weak growth is one of the main risks we see now. To remedy this, it is key to implement structural reforms that will foster potential growth and improve the medium term growth outlook for Europe, including those related to the Single Market and the capital markets union, to completing the banking union, and to improving the performance of the labour market.