European financial integration during the COVID-19 crisis

Prepared by Stefano Borgioli, Carl-Wolfram Horn, Urszula Kochanska, Philippe Molitor and Francesco Paolo Mongelli

Published as part of the ECB Economic Bulletin, Issue 7/2020.

This article provides an overview of financial fragmentation during the coronavirus (COVID-19) crisis and the policies enacted to counter its effects. It does so through the lens of a set of high-frequency indicators for monitoring developments in financial integration. The readings from these indicators are then linked to unfolding economic and political events and to the main policy responses in monetary, fiscal and financial stability policy at the national and European levels. After initial sharp fragmentation, euro area financial integration broadly recovered to pre-crisis levels by mid-September, but not for all indicators. However, this recovery is still fragile and relies on an unprecedented amount of fiscal, monetary and prudential policy support.

1 Introduction

The coronavirus (COVID-19) has created an unprecedented type of shock and has caused a sharp economic downturn. In January 2020 the coronavirus started to spread around the globe, including large parts of Europe. On 30 January the World Health Organisation declared COVID-19 to be a public health emergency of international concern and on 11 March upgraded the threat to pandemic status. As it became clear that extensive containment measures would be required to control the spread of the virus, including lockdowns, economic activity in the euro area began a downturn unprecedented in scale and speed.

The coronavirus is a common health emergency, but it has had differing effects across euro area economies. The pandemic caused shocks to both supply and demand. Supply was constrained by business closures and workers staying at home. The halting of retail activities and disruptions in supply chains were then accompanied by a plunge in the demand for intermediate and final goods.^[1] While the cause of these shocks has been common to all countries, the size of the economic fallout has differed markedly across countries owing to differences in, among other things, initial macroeconomic and financial conditions, the stringency of public health measures and the strength of domestic fiscal measures to support the economy, for example tax deferrals, loan guarantees, social security payments suspension, export guarantees, liquidity assistance and short-term work schemes.

The coronavirus crisis put the real economy and financial markets under extraordinary stress, leading to an initial sharp fragmentation of euro area financial markets. Within days of the first reported case of coronavirus in Europe on 24 January 2020^[2], the composite indicator of systemic stress (CISS) started surging towards levels close to those last seen during the global financial crisis (GFC) of 2008 and the euro area sovereign debt crisis (SDC) of 2011-12 (see the yellow line in Chart 1). Within weeks of the first reported cases, the price-based composite indicator of financial integration^[3] fell towards levels similar to those observed in the months following the introduction of the euro (see the blue line in Chart 1). The drop between February and April 2020 was comparable to the declines it experienced at the start of the GFC of 2008 and the SDC, and the drop in March 2020 was the fourth-largest month-on-month drop in the level of this indicator since the launch of the euro. There were concerns about fragmentation among euro area countries.^[4] A positive correlation between systemic stress and fragmentation in euro area financial markets – a characteristic of previous crises – reappeared. However, one remarkable feature of the COVID-19 crisis, documented in Section 2, has been the fast rebound of financial integration thanks to rapid policy responses and the resilience created by the financial backstops and reforms implemented in the last ten years.

The rapid unfolding of the COVID-19 crisis triggered the need for high-frequency monitoring of financial fragmentation developments across different market segments. The ECB has monitored the state of financial integration in the euro area since the launch of the euro^[5] because fragmented financial markets impede the smooth and uniform transmission of its monetary policy across member countries. In order to monitor euro area financial integration at a higher frequency during the COVID-19 crisis, a toolkit of high-frequency indicators was developed based on the set of indicators presented in an ECB report on financial integration and structure in the euro area and its statistical annex.^[6] The technicalities of this development are presented in Box 1. These high-frequency financial integration indicators are a useful tool for monitoring financial fragmentation and can also be used to illustrate the effects of policy actions in response to the economic downturn.

Euro area policy responses to the crisis were decisive at both the national and supranational levels. This contributed to a rapid reversal of financial fragmentation towards pre-crisis levels by mid-September 2020. The ECB’s prompt monetary policy and supervisory actions provided a first line of defence to soften the disinflationary shock and counteract the adverse effects of financial fragmentation on the effectiveness of its monetary policy (see the top part of Chart 2 for an overview). These responses have taken the form of additional asset purchases through the asset purchase programme (APP) and the new pandemic emergency purchase programme (PEPP), bank lending programmes at highly favourable conditions (targeted longer-term refinancing operations), supervisory measures and coordinated liquidity provision programmes. National fiscal policymakers also reacted immediately throughout the euro area, even in fiscally constrained countries, although the size of fiscal packages varied across countries. In addition, recognising the importance of a centralised crisis response, over the course of the crisis European policymakers have established a variety of pan-European support measures, such as the three safety nets – the temporary SURE scheme (Support to mitigate Unemployment Risks in an Emergency), a loan guarantee scheme by the European Investment Bank (EIB), a new credit line from the European Stability Mechanism (ESM) –, the Next Generation EU fund and the reinforcement of the 2021-2027 Multiannual Financial Framework (MFF) (see Chart 2 for an overview of the European monetary, supervisory and fiscal measures taken). National fiscal measures, which were deployed very rapidly, are not included in this chart. These policies, together with the higher degree of resilience in financial integration achieved through the institutional reforms of the last ten years, have helped to reverse much of the initial sharp fragmentation of financial markets. Financial integration has broadly returned to its pre-crisis levels as of mid-September. This apparent return to the situation before the COVID-19 outbreak, however, is fragile and relies heavily on continued policy support.

The price-based composite indicator of financial integration and its subcomponents suggest that the coronavirus crisis has, broadly speaking, unfolded in four phases. Section 2 describes the developments in financial integration during each of these four phases (see Chart 1 above and Box 1). Phase 1, from 30 January to 25 March 2020, spanned the outbreak of the crisis and the announcement of the PEPP. Phase 2, from 26 March to 7 May, saw increasing economic damage and initial uncertainty regarding a pan-European fiscal response. Phase 3, from 8 May to 21 July, spanned the gradual relaxation of lockdowns and the progress made towards a common European fiscal response and the Next Generation EU decision. Phase 4, from 22 July to 15 September (the cut-off point for this analysis), was a period primarily of maintaining the re-integration achieved through the European monetary and fiscal policy responses during the previous phases. Section 3 concludes the article and provides a cautious outlook. For reasons of space, the international environment and the normalisation of market volatility following policy decisions by other central banks are not discussed here.

It is prudent to mention that the analyses carried out in this article have several limitations. First, owing to the need for high-frequency data, this article is solely focused on price-based measures of financial integration. These capture discrepancies in asset prices across countries and sectors, as opposed to quantity-based measures, which are based on cross-border holdings of different asset classes and usually have a lower frequency of observation. Second, many of our indicators do not control for fundamentals, including firm or country risks. Similarly, particularly in crisis situations, financial markets might act upon forward-looking expectations and significantly overreact to news signalling changes in fundamentals: such changes in general risk attitudes in markets are also not accounted for in this article. Third, the analysis of causal relationships, or counterfactuals, is beyond the scope of this article. Thus, the article offers only a partial perspective of the events which have unfolded during the coronavirus crisis; a more complete assessment of the state of financial integration and structural developments in the euro area financial system would require additional analysis. Despite these limitations, the analysis of the high-frequency indicators in this article provides useful insights into the development of euro area financial integration during this period.

2 Financial integration during the four phases of the crisis

This section documents how the coronavirus crisis strained the resilience of euro area financial integration during each of the four phases set out in Table 1. The time frames chosen are meant to highlight the salient characteristics of the four phases of the major events which took place.

Phase 1: COVID-19 outbreak and the ECB’s stabilisation measures

The first phase of the crisis spanned the period from 30 January to 25 March 2020. This phase was characterised by the COVID-19 outbreak and the ECB’s stabilisation measures.^[17]

Following the outbreak of the coronavirus, initial “alarm-bells” were sounded by the CISS (see Chart 1). Over the course of February the coronavirus spread rapidly throughout the euro area and on 17 February the Eurogroup finance ministers listed the coronavirus outbreak as a new downside risk to economic growth. The first major local lockdown occurred in the Lombardy region in Italy on 23 February. A national lockdown followed on 9 March. Strict containment measures were also enacted in other euro area countries in the ensuing weeks.^[18]

The rapid spread of the coronavirus and the ensuing containment measures in the first quarter of 2020 had a strong impact on financial markets, leading to sharp fragmentation. Signs of financial fragmentation in the euro area emerged in February and gained pace in early March. The CISS for the euro area increased sharply to levels last seen during the GFC and the euro area SDC (see Chart 1). Thereafter, the price-based composite indicator of financial integration signalled rising fragmentation in the euro area during this initial phase, with bond markets being the most affected segment (see the dashboard in Chart 3). Between the end of January and mid-March, the price-based composite indicator fell by roughly 25%. This constituted the fourth-largest decline in this indicator since the introduction of the euro. This strong negative correlation between systemic risk and financial integration was also observed during the GFC and SDC.

In the sovereign bond market, spreads diverged rapidly on the back of sharp downward revisions to the economic and financial outlook paired with extreme uncertainty. Deteriorating fundamentals drove up expectations of large fiscal burdens resulting from public support to firms and households, potential tax shortfalls and pre-existing differences in fiscal space. At the same time, the global financial system was put under extraordinary strain, and stress in the operation of debt markets resurfaced. There was an abrupt rebalancing of portfolios in the direction of greater liquidity and lower leverage. This stoked the risks of forced fire sales in many asset markets, as well as illiquidity spirals and market freezes.^[19] In order to limit self-fulfilling overshooting dynamics and the associated risks to financial stability, central banks initiated new types of liquidity provisions and asset purchases. These policy measures are discussed in more detail below. The divergence in sovereign spreads could be seen at both short and long maturities (see Chart 4) and was driven by more vulnerable member countries with less fiscal space. For 10-year sovereign spreads, the increase was most notable for Italy, which saw its spread rise from 132 basis points on 17 February to 281 basis points on 17 March. In terms of levels, however, sovereign spreads stayed well below the peaks of the SDC in 2011-12. In the earliest stages of the crisis, spread dynamics were consistent with flight-to-quality capital flows into German safe assets, which pushed German yields down further (see Chart 5).

At the beginning of the COVID-19 crisis, corporate bond markets showed dynamics similar to those of their sovereign counterparts. Both financial and non-financial corporate bond yields across major euro area countries more than quadrupled between mid-February and mid-March (see Chart 6). While the uniform increase in corporate bond yields suggests that the pandemic and the resulting containment measures were a common risk to the viability of all euro area firms, the same time period also witnessed significant divergence in yields, with the standard deviation of financial and non-financial corporate bond yields increasing nearly fourfold and threefold respectively between 18 February and 23 March. In particular, the diverging corporate bond yields of Italian financial corporations were consistent with a re-emergence of the sovereign-bank nexus. There was also a sovereign-insurance companies and pension funds nexus, but this is not discussed here.

Equity market fragmentation also increased sharply during the first phase of the crisis (see Chart 7, left panel). This reflects the contraction of economic activity across member countries, including the global stock market crash in the last week of February. However, equity market segmentation was more pronounced in the Group 1 countries, which have smaller economies and less liquid equity markets than the Group 2 countries, which have deeper equity markets (see, respectively, the blue and yellow lines in the left panel of Chart 7).

The ECB announced a comprehensive set of measures between mid-March and end-March. Their aim was to stabilise markets, protect the supply of credit to the economy and neutralise disinflationary developments stemming from the pandemic (see Chart 2). These included temporary capital and operational relief for banks, lending to European banks at negative interest rates, and the PEPP,^[20] which made €750 billion available for security purchases by the end of 2020 (see Chart 2). The PEPP represents a temporary and flexible asset purchase programme of private and public sector securities to counter financial fragmentation and help stabilise the euro area economy in order to ensure the smooth transmission of monetary policy across countries. These measures helped to halt and partially reverse the divergence of bond yields in both the corporate and the sovereign bond markets.^[21]

Despite the market tensions, the improvements in euro area governance and institutional infrastructure since the GFC helped to limit fragmentation. A legacy of the GFC and euro area SDC has been the overhaul of euro area governance and institutional infrastructure with the launch of the ESM and, some years later, the Single Supervisory Mechanism (SSM), among other things. During the COVID-19 crisis, in its capacity as single supervisor, the ECB was able to act in a swift and coordinated manner with respect to banks. The new institutional architecture introduced following the GFC and SDC helped to contain fragmentation. In fact, even during the extreme market volatility seen at the peak of the crisis during Phase 1 and before the PEPP announcement, fragmentation increased much less dramatically than during the GFC and SDC from 2008 to 2012.

Phase 2: Increasing economic damage and uncertainty regarding the European fiscal response

The second phase of the crisis spanned the period from 26 March to 7 May 2020. This phase was characterised by extensive economic and financial damage and the initial challenges of formulating a common European fiscal response to add to national fiscal initiatives.^[22]

In this phase, the pandemic had uneven effects across financial market segments. The data from the subcomponents of the price-based composite indicator suggest that equity markets were the only market segment for which financial integration rebounded during the second phase, as it continued to recede in other market segments (see Chart 8). This re-integration occurred across both more and less liquid equity markets (see Chart 7, left panel) and illustrates the apparent “disconnect” between real economic developments (the outlook was worsening rapidly according to macro and survey data) and equity market performance during the crisis.^[23] However, the dispersion and volatility of forecast equity index returns remained heightened throughout Phases 2 and 3, especially across sectors. This is consistent with the development of equity market volatility. Option-implied equity market volatility rose sharply during the first phase of the crisis to levels last seen at the height of the GFC. It has since receded, but remains above its levels prior to the COVID-19 crisis. Cross-country and sectoral dispersion in euro area equity returns both rose, yet reassuringly the former remains below the latter, signalling that companies have continued to benefit from sectoral and geographic diversification even during the crisis (see Chart 7, right panel)

The different evolutions of equity and sovereign bond markets, furthermore, suggest some degree of “disconnect” between equity and fixed income markets throughout this phase of the crisis. While equity market integration improved in Phase 2, sovereign bond markets in particular lost much of the integration impetus obtained from the PEPP. The levels and cross-country dispersion of sovereign bond spreads increased sharply. These dynamics came to a halt only following the ECB’s decision on 22 April to “freeze” sovereign ratings for its collateralised lending operations and the fourth European Council meeting, which led to the agreement of a first common European fiscal package, consisting of three safety nets: the ESM, EIB, and SURE funds.

The agreement on the €540 billion safety net marked a breakthrough for the pan-European fiscal response to the COVID-19 crisis. The agreement on a three-pronged safety net during the fourth dedicated European Council meeting on 23 April was a major step in the formulation of a common European fiscal response. This safety net comprises the €100 billion SURE instrument, a €200 billion pan-European guarantee fund for loans to companies by the EIB and a €240 billion pandemic crisis support credit line by the ESM. Furthermore, during this meeting the European Council tasked the European Commission with developing a proposal for a European crisis recovery fund, even though diverse views remained regarding the make-up of such a fund in terms of the distribution of grants and loans. In retrospect, the policy discussions that took place at the earlier European Council meetings on this topic were necessary for reaching consensus on the above safety nets and ultimately to agree on the Next Generation EU fund, which had many of the desired effects on financial integration.

These positive signs of progress towards a common European fiscal response to the pandemic supported market confidence and marked a turning point in overall financial integration (see Chart 1). They revived the re-integration trend in sovereign and corporate bond markets set in motion by the PEPP and other monetary and financial stability measures (see Chart 2). Other measures that have contributed to this re-integration of financial markets were the ECB’s decision on 22 April to “freeze” ratings for its collateralised lending operations, i.e. to uphold the eligibility of marketable assets that fulfilled minimum credit quality requirements in the event of a deterioration in credit ratings.^[24]

Phase 3: Relaxation of lockdowns and the Next Generation EU fund

The third phase of the crisis spanned the period from 8 May to 21 July 2020. This phase was characterised by a gradual relaxation of lockdowns and the agreement on the Next Generation EU fund.^[25]

The third phase of the crisis saw several events that supported financial integration. These events include the Franco-German and European Commission proposals for an EU Recovery Fund, a gradual relaxation of lockdowns, a larger-than-expected €600 billion expansion of the PEPP purchase envelope and eventual agreement on the Next Generation EU recovery fund. The subcomponents of the price-based composite indicator point to positive financial integration developments across markets during this phase (see Chart 9).

Financial integration improved across market segments against the background of a mixed data flow. On the one hand, new data during this phase showed declining COVID-19 infections and slowing death rates, which led to the gradual relaxation of European containment measures. On the other hand, data show historically negative economic growth and downward forecast revisions. In this environment, the Franco-German proposal on 18 May for a €500 billion fund of grants and the European Commission’s Next Generation EU proposal on 27 May for €750 billion of grants and loans (both funded through the EU budget) led to sizeable reductions and some material reconvergence of sovereign spreads and corporate yields, notably for vulnerable countries (see Charts 4, 5 and 6). These positive developments were further reinforced by the decision of the ECB’s Governing Council on 4 June to increase the size of the PEPP by €600 billion (to a total of €1,350 billion) and to extend the programme’s reinvestment period at least until the end of 2022.

The joint European fiscal response is a milestone which reinforces financial integration. The calming effects of these proposals in underpinning the European recovery (along with other parallel factors) are also reflected in euro area corporate bond yields, though with some delay for non-financial corporate bond yields. Depending on the country considered, most or all of the yield increases observed by the end of April/early May had been corrected by late May. The different sizes of the corporate bond markets in different euro area countries − both in absolute terms and relative to the countries’ respective economies − may explain some of the bond yield and fragmentation developments.^[26]

The end of this phase was marked by the agreement on the EU Recovery and Resilience Facility – under the Next Generation EU fund proposal – and the 2021-27 MFF. The agreement resolved part of the uncertainty around a common European fiscal response^[27] and had an immediate positive effect on financial integration across a broad set of markets, most notably sovereign and corporate bond markets. It thus reinforced the positive integration developments following the Franco-German and European Commission proposals in May.

There was less fragmentation in money markets than in other financial market segments. While money markets had been exhibiting some signs of fragmentation since the start of Phase 1 and well into Phase 2 − albeit to a lesser degree than other markets − indicators for the money market segment started falling to lower dispersion levels in late April 2020 (see the left panel of Chart 10). The different lending operations and the adjustments to lending criteria and eligible collateral supported a gradual reduction of dispersion, in particular for unsecured money market rates such as the €STR. The dispersion of secured money market rates spiked around key dates in the coronavirus crisis on account of flight-to-quality dynamics or around futures delivery dates owing to collateral scarcity. In early May 2020 it again approached pre-crisis levels, where it broadly continued to fluctuate (see right panel of Chart 10).

Phase 4: Sustained signs of financial normalisation

The fourth phase of the crisis spanned the period from 22 July to 15 September and was characterised by an improvement in measured financial integration across a wide range of indicators.^[28]

The broad-based improvement in financial integration continued during this phase. The data from the price-based composite indicator and its subcomponents suggest that throughout this phase of the crisis, the agreement on the EU Recovery Fund and the MFF continued to have a positive impact on the level of financial integration. Indeed, the composite indicator recovered to its pre-crisis levels at the end of August (see Chart 1). The continuing re-integration trend in European financial markets is also illustrated, for instance, by the decline in the level and dispersion of 10-year sovereign spreads throughout the fourth phase of the crisis (see Chart 5). Furthermore, the corporate bond market showed a continued downward trend towards levels last observed in March 2020, driven also by low primary market activity and relatively low market liquidity over the summer period.

The current stabilisation and apparent return to the situation before the COVID-19 outbreak, however, calls for several qualifications. The return of financial integration measures towards pre-crisis levels has to be seen against the background of the substantial amount of monetary and fiscal stimulus on which it relies and which is essential for its sustainability. Although some of the uncertainty has been resolved following the agreement on a European recovery instrument, substantial uncertainty about the post-crisis economic recovery remains, in particular in view of a renewed increase in infection rates across European countries, which raises the possibility of a new round of lockdown measures, and the pending ratification of the Next Generation EU fund in national parliaments.

3 Conclusion

This article has presented a set of high-frequency indicators to monitor developments in financial integration during the COVID-19 crisis. The article focuses on a price-based composite indicator of financial integration and its subcomponents for the money, bond, equity and banking markets. An original contribution of this article is to transform them – with the support of big data techniques – so that they give higher-frequency observations. The high-frequency monitoring toolkit presented here is based on analysis conducted at the ECB and in the Eurosystem. It includes new high-frequency indicators for the money market along with various indicators tracking sovereign and corporate bond markets. This toolkit is flexible and can be expanded over time.

The data from these high-frequency financial indicators can be used to track the unfolding of the COVID-19 crisis and interpret the effects of monetary, fiscal and financial policy responses from the viewpoint of euro area financial integration. The indicators suggest that the most significant challenge for the resilience of financial integration in the euro area came in the initial phases of the COVID-19 crisis. The onset of the crisis was especially severe in terms of fragmentation developments, especially prior to the PEPP announcement. Thereafter, sustained signs of financial re-integration emerged as progress was made on a joint European fiscal response, highlighting the powerful effects of monetary and fiscal policy coordination in weathering economic crises.

A nuanced picture emerges when cross-checking the price-based composite indicator of financial integration against the segment-specific indicators. The composite indicator of financial integration shows a trough in mid-April 2020 – but by mid-August 2020 surpasses the levels seen prior to the coronavirus crisis. However, such re-integration is not observed in all market segments; nor do all euro area countries benefit from it to the same degree. Money markets have been a strong contributor to the rebound of price-based financial integration to early 2020 levels. For both sovereign and corporate bond markets, the re-integration trend stabilised as late as August 2020, and integration only returned to pre-crisis levels towards the end of the reporting period. Equity market integration displays diverging paths across countries and has picked up slightly compared with early July 2020, but remains around pre-crisis levels.

At present, the re-integration of euro area financial markets is still fragile and uneven, and the gradual return to the situation before the COVID-19 outbreak relies on the unprecedented amount of monetary and fiscal stimulus in place. While many indicators of financial integration show an improvement throughout the third and fourth phases of the crisis, this re-integration trend is subject to the risk of further waves of infections and renewed lockdown measures.