Jumpstarting the Eurozone: Maestro Draghi’s New Ouverture (9/8)     Print Email

 

By James David Spellman, Principal Strategic Communications LLC.

The European Central Bank last week (September 4) unexpectedly lowered interests rates again and pushed bank deposit rates slightly more deeply into negative territory, as low inflation, weak growth, and sluggish lending to businesses suggested the Eurozone’s recovery was “losing momentum,” President Mario Draghi said. While the rate cuts grabbed the headlines, more significant are two new initiatives Draghi also unveiled to pump money into the region’s economy. Immediately afterward, the euro tumbled, bond yields fell, and stocks rallied.

The ECB lending rate for banks now stands at 0.05 percent (from 0.15 percent since June), what economists call “free money” since the borrowing costs are negligible. Second, the rate banks earn for depositing cash with the central bank for safekeeping fell to negative 0.2 percent from negative 0.1 percent instituted in June. Depositors are paying the ECB to hold their funds rather than earning interest. Insisting that there is no threat of deflation, Draghi signaled that these rates cuts – at the “lower bound” -- may be the last since the ability of low rates to stimulate growth is likely exhausted.

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Source: The Wall Street Journal, September 4, 2014.

Hope rests increasingly with the ECB’s new round of “quantitative easing lite” (QE) measures, all uncharted territory, to jumpstart the Eurozone by expanding money supply, thereby incentivizing banks to lend more at lower rates.

In October, the ECB will start buying “covered bonds” (debt backed by cash flows) and “packages” of loans and other securities that banks create by amassing mortgages, credit card debt, and auto loans into financial instruments that, in turn, are sold to investors (“asset-backed securities”). More demand for these allows banks to lower the cost of credit, which attracts more businesses to borrow funds they can invest in expansion and modernization.

The ECB flagged €400 billion in additional “targeted long-term refinancing options”(TLTROs) – low- interest, long-term refinancing loans to boost lending to the non-financial sector (the “real economy” of small to medium-size enterprises), although household mortgages would be excluded. Issuance of European securities peaked before the global financial crisis in 2008, and has been very slow to recover over the last two years, evidence of economic weakness.

This new tranche of TLTROs will mature in 2018, but if a bank fails to lend sufficient money it must repay the ECB loan in 2016.   Although details will be released in October, banks apparently will be able to issue loans totaling three times their quarterly net lending levels to the non-financial sector. This suggests asset growth of approximately €1 trillion ($1.4 trillion), which would raise the ECB's balance sheet to approximately €3 trillion, or 33 per cent of GDP, according to Richard Grace, CBA head of international economics.[1] The ECB’s intent, Draghi said, is to bring its balance sheet back to the 2012 level.

As emergency responses to the financial crisis, the ECB twice before in 2009-2010 and 2011-12 purchased covered bonds totaling €75 billion ($100 billion), but the central bank did not offer deposits equal in value to the bonds it held, so-called “sterilization.”

Despite vows the ECB will do “whatever it takes,” how much more QE it can pursue is constrained by the politics of the ECB’s governing council, comprised of central bank governors for the 18 Eurozone countries. “The governing council is unanimous in its commitment to using additional unconventional instruments,” Draghi first said at the news conference last week.   But he later hedged this by acknowledging resistance from some of the council when characterizing the vote for QE lite as a “comfortable majority.” Germany’s Bundesbank head opposed the measures, citing the need for more deliberations and questioning the timing of implementation.

Citing a paper published by the think-tank Breughel[2], an Economist blog post questions whether the new QE measures will have much impact given the small size of the market for asset-backed securities – around €1 trillion ($1.3 trillion) – relative to the Eurozone economy -- about €14 trillion ($18.451 trillion). Further, the ECB is highly unlikely to buy much of the instruments being sold because they are complex, lack transparency, and carry high risks.[3]

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Source: http://www.bruegel.org/uploads/RTEmagicC_140724_abs2.png.png

As Draghi himself and others on the ECB governing council have stressed repeatedly, Europe’s growth ultimately rests with the fiscal policies member states take, their “structural reforms.”   “Draghi has made clear many times that the ECB cannot fix the Eurozone economy alone – and today he again called on government to support European growth with determined structural reforms,” said Stephanie Flanders of JP Morgan Asset Management. “But he has also said that the ECB could not let failure on the reform front get in the way of its duty to get inflation back towards 2%.”

The difficulties and limits of what Eurozone countries can do is demonstrated by the implosion recently of France’s cabinet. Prime Minister Manuel Valls forced three out of the cabinet, including the minister of the economy, Arnaud Montebourg, to bring in ministers whose views are “consistent with the direction” of austerity that the unpopular President François Hollande set. The outspoken Montebourg told Le Monde that France was trapped in an austerity policy Germany imposed across Europe. The country can no longer be “pushed around” by the deficit hawks, he said.

Ahead, the markets’ readings of the ECB’s unconventional actions will be an important short-term barometer but increasingly driving market sentiment over the long term will be the member-states’ actions to promote growth.   Some point to much-needed, pro-growth fiscal actions  Others believe the insufficient flexibility in labor markets and excessive regulations must be addressed. None of these are fast-track solutions.

 



[1]Luke Malpass, “ECB explained: What do negative rates mean?” Sydney Morning Herald, September 5, 2014. Available at:

http://www.smh.com.au/business/markets/ecb-explained-what-do-negative-rates-mean-20140905-10ctno.html#ixzz3Cg5P3e67 .

[2] Carlo Altomonte and Patrizia Bussoli, “Asset Backed Securities the Key to Unlocking Europe’s Credit Markets?” July 24, 2014. Available at:

http://www.bruegel.org/publications/publication-detail/publication/842-asset-backed-securities-the-key-to-unlocking-europes-credit-markets/ .

[3] “ECB Surprise Moves: Busy, Busy.” September 4, 2014. The Economist Free Exchange blog. Available at:   http://www.economist.com/blogs/freeexchange/2014/09/surprise-ecb-moves .