If there is one central bank that has remained an enigma for me in my decade and a half of monetary policy watching, it is the European Central Bank (ECB). While the US Fed and other central banks like the Bank of Japan have been more than aggressive in fighting their economic slowdown, the European monetary authority’s responses remain remarkably tepid in relation to the myriad problems the euro zone continues to face. The Byzantine European Union bureaucracy based in sleepy Brussels, is known and routinely mocked for its sluggishness and lack of initiative. Its monetary cousin, the Frankfurt-based ECB, does not seem to be much different.
Take the bunch of announcements that the ECB made on the June 5 that the media initially described as a “big bazooka of policies”, but ultimately turned out to be really a set of minor tweaks to the extant policy. These seem hardly adequate to prop up growth or harness the deflationary trends that continue to plague the region. Thus, it wasn’t particularly surprising to see the markets shrug these measures off almost completely and take another round of disappointment in its stride.
This is roughly what the ECB did. First, it announced small cuts in its various short-term lending and deposit facilities that were broadly in line with market expectations. The 10-basis point cut in the bank deposit rate that actually produces a negative deposit rate for the first time (banks will have to have to pay the central bank to park their excess funds money with it), is interesting and perhaps even amusing to analyse. It is based on the assumption that this will, as think tank Capital Economics’ European economist Jennifer McKeown succinctly put, turn excess reserves into the proverbial “hot potato” and spur banks to withdraw deposits from the central bank, and instead lend to the private sector. In the absence of any meaningful attempts to shore up growth (and credit demand), all this is likely to do is hurt the profitability of banks.
The second significant measure that came remotely close to quantitative easing was the decision not to sterilise (or mop up in lay terms) the liquidity created through the central banks securities market operations, in which the central bank had effectively printed euros to buy distressed sovereign bonds. If you go entirely by the textbook, this does constitute quantitative, but its quantum of roughly 1.6 per cent of the region’s gross domestic product (GDP) is the cliched drop in the ocean. To put this in perspective, the Bank of England and the US Fed’s quantitative easing programme amounted to about 20 per cent of GDP.
The third measure that looks more significant – at least in terms of its quantum – is the TLTRO (targeted long-term refinance operation) that enables banks to borrow from the central bank of up to seven per cent of their non-mortgage obligations to subsequently deploy in the credit markets. If all banks were to avail of this limit, this would add up to about euro 400 billion, a respectable seven per cent plus of GDP. Here again, it seems to be a case of putting the cart before the horse. Banks would only avail of their limits if there are profitable channels to deploy them. In an environment of low growth and sluggish credit demand, these channels would be hard to find and only a small fraction of the upper limit on the liquidity that is (theoretically) available will actually find its way into the market.
The ECB was somewhat emphatic about the fact that these set of measures were not all they were going to do. In reply to a press question on what the ECB planned to do next, the erudite and exquisitely pomaded President Mario Draghi retorted, “Are we finished? No.”
One possibility that the ECB is toying with is an American-style quantitative easing programme, by purchasing asset backed-securities (ABS), but the problem is that the market for ABS is pretty small at about euro 200 billion. To cut to the chase, I essentially see two problems with the ECB’s strategy. First, not only are its measures grossly inadequate in terms of their quantum but they are premised on the assumption that the supply of liquidity or credit is holding back growth. This is certainly not the case as weak demand for goods and services continues to plague the region, and the implication is that small changes in rates or liquidity will make a tinker’s dam of a difference.
Second, if (and this is a big ‘if’) indeed monetary stimulus is the answer to Europe’s growth woes, the ECB will have to consider an actual big bazooka of monetary stimulus through substantially larger purchases of sovereign and corporate bonds. Apart from (hopefully) stimulating growth, more euros in the system will also lead to a depreciation in the currency that economists of every hue and shape agree is grossly overvalued.
Tailpiece: The ISIS’ merciless “jihadis” hold the key to the future of the financial markets. This comes at a time when some interest was returning to emerging markets bucked up partly by the Indian election results and the possibility of regime change driving better governance in other economies such as Brazil and Indonesia. The fear is that if oil prices continue to rise as supply from Iraq’s oilfields disappear, the sell “current account deficit” emerging markets trade could be back with a bang. The rupee will not be spared and the bloodlust of the ISIS rebels will be pitted against the recently restocked arsenal of dollar reserves of the RBI.
The author is with HDFC Bank.
These views are personal