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Satyajit Das: The ECB’s ‘policy fireworks’ won’t have anyone turning cartwheels

Das Capital: The measures will support  markets but they are unlikely to restore economic activity

The borrowing costs of European nations suggest the eurozone economic crisis is over and rehabilitation complete.

Ten-year government bond rates for Spain, Portugal, Ireland and Greece are 2.44, 3.47, 1.99 and 5.78 per cent respectively. Comparable rates for the US, UK, Canada and Australia are 2.36, 2.40, 2.01 and 3.34 per cent. A little over a year after requiring a bailout, Cyprus returned to the bond markets in June with a €750m (£600m) five-year bond at 4.85 per cent, which was substantially oversubscribed.

Yet these rates do not reflect fundamental factors, merely the effect of massive liquidity injections from the European Central Bank (ECB).

The recovery from the recession is weak. The risk of a relapse is ever present. Growth, employment and investment are moribund. Disinflation or deflation risks are increasing, threatening to make a difficult debt problem unmanageable. The inadequacy of policy instruments is increasingly evident.

Responding to external pressure and its own oft-stated willingness to act, the ECB announced a series of measures in June designed to counter “lowflation”, increase the supply of credit to create growth, and weaken the euro to boost exporters’ competitiveness and counter the disinflationary pressures of a strong currency.

Official euro rates were, de facto, reduced to the lower bound of zero. A negative deposit rate was instituted for certain balances held with the ECB.

The central bank ended the sterilisation of securities market purchases, injecting around €160bn into eurozone money markets, but the centrepiece was a new funding-for-lending scheme – the targeted longer-term refinancing operation (TLTROs) – under which it will finance up to  7 per cent of bank loans to non-financial corporations. Assuming around  €5.7 trillion of eligible assets, the TLTROs equal new funding of around €400bn for four years at an effective interest rate of 0.25 per cent.

In addition, the ECB proposed purchases of asset-backed securities to increase funding for businesses, though details are still to be worked out.

European optimists believe that the ECB’s “monetary policy fireworks” represent a decisive turning point. Pessimists point to previous false dawns and ineffective policies.

The interest rate cuts were largely a technical exercise, having little impact on market rates and therefore illusory. German rates, based on its domestic condition, should be around 4.65 per cent but would need to be minus  10.75 per cent for Spain or minus  19.25 per cent for Greece.

Meanwhile the Danish experiment with negative interest rates suggests low efficacy, with limited change in monetary conditions.

The TLTROs assume there is demand for loans. But with the strong likelihood that the eurozone is in a Japanese-style balance sheet recession, credit demand may remain weak.

Banks may also not be willing to lend as they are still rebuilding capital. This reflects the effects of the recession and new regulations. Banks’ ability to provide credit could also be affected by the ECB’s Asset Quality Review, which may require banks to write off debt and raise additional capital.

The TLTROs are designed to provide low-cost funding for businesses, especially smaller ones, to spur employment and investment. But given the fungible nature of money and the separation of banks’ assets and liabilities, the ECB will have limited control over the use of the funds.

In practice, the TLTROs may marginally increase the availability of credit in the eurozone. It is likely they will provide cheap funding for banks to buy government and corporate bonds.  However, the sharp rise in bank share prices reflects the stock market belief that they will boost bank profits rather than economic activity.

Increased bank holding of government bonds also increases the dangerous feedback relationship between sovereigns and financial institutions, referred to as the “doom loop”. 

Additionally, ECB purchases of asset-backed securities are unlikely to be effective in the near term because outstanding volumes are modest. This means it will need to provide incentives to banks to create them in the first place, and there are significant technical hurdles to creating a sizeable European ABS market. The ECB requires simple, transparent structures, which may not be readily available in sufficient size to have the desired impact. 

In addition, the ECB’s encouragement of ABS issuance will face opposition from European banking regulators, which are in the process of tightening regulations, including increasing the amount of capital to be held against these securities.

While the policy measures will continue to support bond, stock and property prices, they are unlikely to restore growth or economic activity.

Satyajit Das is a former banker and author of ‘Extreme Money’ and ‘Traders, Guns & Money’