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Wicksell's Eurozone Test

Wicksell's Eurozone Test

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Published by: mordenviabank on Sep 01, 2011
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By Thomas Aubrey, Managing Director, Fitch Solutions
Since the European sovereign debt crisis began over 18 months ago, the debate over whetherthe Eurozone is an optimum currency area has re-ignited. This is largely due to the biurcationo the European economy between its relatively robust core and its debt-ridden periphery. As aresult o Europe’s “two-speed” economy, many commentators including Sir Samuel Brittan havehighlighted that the Eurozone is ar rom being a sustainable or optimum currency area. However,these concerns did not stop Estonia rom becoming the latest country to join the single currency inJanuary o this year. In many respects, this is a ringing endorsement o the euro project, right in themiddle o the worst European economic crisis since the creation o the European Union itsel.
The traditional argument or countries to join a common currency, is that they will benet rom increasedtrade in goods and services, higher levels o investment and alling transaction costs, as well as reducedoreign exchange volatility. The challenge is o course whether these benets outweigh the loss o theability to control the rate o interest, combined with a foating exchange rate during times o economicstress. As a result o this debate, a multitude o tests have been proposed to identiy whether a countrywould indeed benet rom joining a currency union.However, one test that has in general been absent rom the text books, is to use a Wicksellian rameworkto compare whether the singular rate o interest in a currency zone is appropriate or each individualcountry. An empirical analysis o France, Germany, Spain and Ireland using a Wicksellian rameworkhighlights two issues. The rst is that monetary policy in the 1990s and 2000s was too lax – uellingasset bubbles, which was also the case in the USA and the UK. This suggests that the current monetaryramework and its ocus on infation/money supply targeting is unable to explain and prevent assetprice misalignments. Secondly, the rate o interest set by the European Central Bank (ECB) is moreappropriate or core European countries but less so or peripheral countries such as Ireland, withsignicant economic consequences.
Infation, infation everywhere?
On 7 July 2011, the ECB raised interest rates to 1.5% in the light o upside risks to price stability – infationin the Eurozone is now at 2.7%. The challenge or the ECB is clearly to nd the right balance betweenmaintaining price stability while acilitating economic activity across the heterogeneous Eurozone.As discussed in Proting rom Monetary Policy (Q2 2011), Knut Wicksell, in Interest and Prices, argued that astable economy can be maintained by ensuring that the money rate o interest (cost o capital) is equivalentto the natural rate o interest (return on capital). When the money rate o interest is signicantly lower thanthe natural rate o interest an economic boom will be triggered, and conversely when the money rate ointerest is higher than the natural rate o interest, an economic depression will be triggered.
Using Wicksell’s interest rate ramework, our countries were analysed – Germany, France, Ireland andSpain – rom 1995 to 2010. This included the pre-euro period which actors in individual central banks’interest rate policy in relation to exchange rate convergence. The returns on capital were generatedby looking at the entire constituent base o the Datastream total market indices or each country. Thecompanies were grouped into six sectors corresponding to the NACE statistical classication used toidentiy the sources o gross value added in national accounts by Eurostat. This allows the aggregatedreturn on capital to be weighted by the contribution to gross value added. For nancial institutions, thereturn on equity was used instead o return on capital. This is because with the exception o hybrid capital,debt capital is generally used to und operating assets rather than or capital purposes. Ater assemblingthe datasets, a data quality check was carried out on the individual companies or erroneous datasets oroutliers due to various accounting treatments. These were eliminated rom the analysis.
What goes up must come down?
Chart 1 shows the results o the weighted average return on capital or the our countries. Ireland,Spain and Germany all had high returns on capital until 2002 when Germany dropped o considerably,leaving Spain and Ireland as the best perormers. Ireland then led the pack by a considerable marginbetween 2003 and 2007, with returns on capital signicantly higher than the other three countries.However, the onset o the credit crisis has seen the return on capital in Ireland severely curtailed, withIrish companies on a weighted basis now showing a negative return on capital, largely driven by thetroubled construction and banking sectors.The next step in the analysis is to determine the cost o capital in order to calculate the returns abovethe cost o capital, or the “Wicksellian dierential”. The cost o capital or a portolio o companies isdetermined by the cost o debt and o equity. For this analysis the ve-year bond yield or each country isused as a proxy or the cost o debt or companies within each country.
Clearly the actual cost o undingor companies in the Datastream indices will dier rom the sovereign bond yield, in that many companieswill have to pay higher costs than the sovereign yield. However, in the last 18 months, some corporateshave seen their cost o debt unding all relative to sovereign debt, particularly in peripheral countries.
Chart 1:Return on investedcapital – Germany,France, Ireland, Spain
Source: Thomson Reuters Datastream.
Chart 2:Wicksellian differential– Germany, France,Ireland, Spain
Source: Thomson Reuters Datastream.
In terms o calculating the cost o equity, there is no standard approach to generating estimates.
However,it would appear more appropriate to use an implied equity risk premium that calculates expected returns,given that corporations make investment decisions on a orward-looking basis. In times o economic stress,the cost o investing in equities tends to rise due to increased perceived risk, and as the equity market booms,the cost o equity tends to all as perceived risk alls. As the costs o equity and debt are correlated, andgenerating a cost o equity is problematic, only the cost o debt will be taken into account in this analysis.Hence, it is worth noting that the Wicksellian dierential includes the cost o equity.
Optimal currency union?
Chart 2 plots the Wicksellian dierential or each country. The urther away rom zero the dierential is,the higher the level o excess liquidity. Moreover, the longer the dierential remains at high levels, thegeneration o excess liquidity accelerates. With that in mind, chart 2 shows that, according to Wicksell’sramework, interest rates in the 1990s were too low or the Irish and German economies, driving excessliquidity. However, by the early 2000s the return on capital was alling or Germany but increasing orSpain. By 2005 all economies were generating signicant excess liquidity due to the large Wickselliandierential. Ireland over the period demonstrated a signicant, and more importantly, sustainedWicksellian dierential due to the diering returns on capital and a singular interest rate.The Wicksellian ramework also shows that post-crisis, the return on capital in the core countries oFrance and Germany remains strong, thus increasing the likelihood o an increase in interest rates due topotential rising infation. However, i interest rates do continue to rise, Wicksell’s approach highlights thatIreland, with its negative returns on capital, may be adversely impacted as Japan was in the 1990s, wherethe cost o capital was greater than the return on capital.Sustained high levels o Wicksellian dierentials lead to excess liquidity being generated, thereore itshould be easible to spot this excess liquidity with available data. Indeed, a cursory look at asset pricesin Germany, Ireland and Spain clearly demonstrates where excess liquidity fowed to.

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