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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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04/08/2013

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© THOMSON REUTERS 2011
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3RD QUARTER 2011
WICKSELL’S EUROZONE TEST
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.
FEATURE
 
© THOMSON REUTERS 2011
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3RD QUARTER 2011
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.
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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.
 
© THOMSON REUTERS 2011
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3RD QUARTER 2011
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.
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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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