FEATURE

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 whether the Eurozone is an optimum currency area has re-ignited. This is largely due to the bifurcation of the European economy between its relatively robust core and its debt-ridden periphery. As a result of Europe’s “two-speed” economy, many commentators including Sir Samuel Brittan have highlighted that the Eurozone is far from being a sustainable or optimum currency area. However, these concerns did not stop Estonia from becoming the latest country to join the single currency in January of this year. In many respects, this is a ringing endorsement of the euro project, right in the middle of the worst European economic crisis since the creation of the European Union itself. The traditional argument for countries to join a common currency, is that they will benefit from increased trade in goods and services, higher levels of investment and falling transaction costs, as well as reduced foreign exchange volatility. The challenge is of course whether these benefits outweigh the loss of the ability to control the rate of interest, combined with a floating exchange rate during times of economic stress. As a result of this debate, a multitude of tests have been proposed to identify whether a country would indeed benefit from joining a currency union. However, one test that has in general been absent from the text books, is to use a Wicksellian framework to compare whether the singular rate of interest in a currency zone is appropriate for each individual country. An empirical analysis of France, Germany, Spain and Ireland using a Wicksellian framework highlights two issues. The first is that monetary policy in the 1990s and 2000s was too lax – fuelling asset bubbles, which was also the case in the USA and the UK. This suggests that the current monetary framework and its focus on inflation/money supply targeting is unable to explain and prevent asset price misalignments. Secondly, the rate of interest set by the European Central Bank (ECB) is more appropriate for core European countries but less so for peripheral countries such as Ireland, with significant economic consequences. Inflation, inflation everywhere? On 7 July 2011, the ECB raised interest rates to 1.5% in the light of upside risks to price stability – inflation in the Eurozone is now at 2.7%. The challenge for the ECB is clearly to find the right balance between maintaining price stability while facilitating economic activity across the heterogeneous Eurozone. As discussed in Profiting from Monetary Policy (Q2 2011), Knut Wicksell, in Interest and Prices, argued that a stable economy can be maintained by ensuring that the money rate of interest (cost of capital) is equivalent to the natural rate of interest (return on capital). When the money rate of interest is significantly lower than the natural rate of interest an economic boom will be triggered, and conversely when the money rate of interest is higher than the natural rate of interest, an economic depression will be triggered.

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Using Wicksell’s interest rate framework, four countries were analysed – Germany, France, Ireland and Spain – from 1995 to 2010. This included the pre-euro period which factors in individual central banks’ interest rate policy in relation to exchange rate convergence. The returns on capital were generated by looking at the entire constituent base of the Datastream total market indices for each country. The companies were grouped into six sectors corresponding to the NACE statistical classification used to identify the sources of gross value added in national accounts by Eurostat. This allows the aggregated return on capital to be weighted by the contribution to gross value added. For financial institutions, the return on equity was used instead of return on capital. This is because with the exception of hybrid capital, debt capital is generally used to fund operating assets rather than for capital purposes. After assembling the datasets, a data quality check was carried out on the individual companies for erroneous datasets or outliers due to various accounting treatments. These were eliminated from the analysis. What goes up must come down? Chart 1 shows the results of the weighted average return on capital for the four countries. Ireland, Spain and Germany all had high returns on capital until 2002 when Germany dropped off considerably, leaving Spain and Ireland as the best performers. Ireland then led the pack by a considerable margin between 2003 and 2007, with returns on capital significantly higher than the other three countries. However, the onset of the credit crisis has seen the return on capital in Ireland severely curtailed, with Irish companies on a weighted basis now showing a negative return on capital, largely driven by the troubled construction and banking sectors.
Chart 1: Return on invested capital – Germany, France, Ireland, Spain

Source: Thomson Reuters Datastream. The next step in the analysis is to determine the cost of capital in order to calculate the returns above the cost of capital, or the “Wicksellian differential”. The cost of capital for a portfolio of companies is determined by the cost of debt and of equity. For this analysis the five-year bond yield for each country is used as a proxy for the cost of debt for companies within each country.1 Clearly the actual cost of funding for companies in the Datastream indices will differ from the sovereign bond yield, in that many companies will have to pay higher costs than the sovereign yield. However, in the last 18 months, some corporates have seen their cost of debt funding fall relative to sovereign debt, particularly in peripheral countries.

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In terms of calculating the cost of equity, there is no standard approach to generating estimates. 2 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 forward-looking basis. In times of economic stress, the cost of investing in equities tends to rise due to increased perceived risk, and as the equity market booms, the cost of equity tends to fall as perceived risk falls. As the costs of equity and debt are correlated, and generating a cost of equity is problematic, only the cost of debt will be taken into account in this analysis. Hence, it is worth noting that the Wicksellian differential includes the cost of equity. Optimal currency union? Chart 2 plots the Wicksellian differential for each country. The further away from zero the differential is, the higher the level of excess liquidity. Moreover, the longer the differential remains at high levels, the generation of excess liquidity accelerates. With that in mind, chart 2 shows that, according to Wicksell’s framework, interest rates in the 1990s were too low for the Irish and German economies, driving excess liquidity. However, by the early 2000s the return on capital was falling for Germany but increasing for Spain. By 2005 all economies were generating significant excess liquidity due to the large Wicksellian differential. Ireland over the period demonstrated a significant, and more importantly, sustained Wicksellian differential due to the differing returns on capital and a singular interest rate. The Wicksellian framework also shows that post-crisis, the return on capital in the core countries of France and Germany remains strong, thus increasing the likelihood of an increase in interest rates due to potential rising inflation. However, if interest rates do continue to rise, Wicksell’s approach highlights that Ireland, with its negative returns on capital, may be adversely impacted as Japan was in the 1990s, where the cost of capital was greater than the return on capital.
Chart 2: Wicksellian differential – Germany, France, Ireland, Spain

Source: Thomson Reuters Datastream. Sustained high levels of Wicksellian differentials lead to excess liquidity being generated, therefore it should be feasible to spot this excess liquidity with available data. Indeed, a cursory look at asset prices in Germany, Ireland and Spain clearly demonstrates where excess liquidity flowed to.

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It’s all in the liquidity Chart 3 shows the Wicksellian differential plotted against asset price bubbles from Germany, Ireland and Spain over the period. The asset prices have been rebased to 100 and plotted on the right-hand axis. The first point of interest is that the sustained high level of the Wicksellian differential for Germany can be seen in the German tech bubble, sending asset prices soaring and then crashing down as the German economy demonstrated a period of lower returns. Ireland however maintained high levels of the Wicksellian differential in the decade leading up to the crisis, revealing itself in soaring house prices. Interestingly, the Spanish house price boom was significantly lower than in Ireland. This can be explained as Spain had a consistently lower Wicksellian differential over the period, generating less excess liquidity than Ireland.
Chart 3: Wicksellian differential – Germany, France, Ireland, Spain vs German, Irish, Spanish asset prices

Source: Thomson Reuters Datastream.

Conclusion In summary, Wicksell’s monetary framework provides a unique insight into potential mismatches with individual member countries of the Eurozone, which in turn can highlight to market participants and central bankers liquidity issues and asset price misalignments. According to Wicksell’s framework, monetary policy was too lax in the 1990s as well as in the period leading up to the credit crisis – as was the case in the USA and UK. Moreover, according to Wicksell, the rate of interest set by the ECB has clearly not been as appropriate for peripheral countries such as Ireland throughout its membership of the Eurozone, resulting in boom and bust. This provides further evidence substantiating Sir Samuel Brittan’s comments as to whether the euro has been a sustainable or optimal currency area for Ireland. As for Estonia, it may well be that it has a Wicksellian differential similar to that of Germany and France, but the limited data available on listed Estonia companies makes this difficult to ascertain. The views expressed in this article are the personal opinions of the author. The contents of this article are not indicative of the opinions, commentaries or analyses of Fitch’s rating analysts, and are therefore separate and distinct from rating analyst activity, actions and opinions. Nothing in this commentary is a recommendation to buy, sell or hold any security.

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Further reading Aubrey, Thomas – Profiting from Monetary Policy, Q2 2011, Thomson Reuters Brittan, Samuel – Greek light on an over-hasty project, 18 February 2010, Financial Times Brittan, Samuel – Who is winning the race for recovery? 12 May 2011, Financial Times Brittan, Samuel – The euro is still far from out of danger, 29 July 2011, Financial Times Damodaran, Aswath (2011) – Equity Risk Premiums (ERP): Determinants, Estimation, and Implications, http://pages.stern.nyu.edu/~adamodar/ Mundell, Robert (1961) A Theory of Optimum Currency Areas, American Economic Review Wicksell, Knut – Interest and Prices Fitch Ratings analysis shows average debt maturity profile of non-financial European rated issuers is 5.3 years. 2 For a summary of the different approaches see Damodaran, Aswath (2011) – Equity Risk Premiums (ERP): Determinants, Estimation, and Implications.
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