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Wednesday, June 05, 2013

More of the same expected from the ECB despite eurozone economic malaise

The ECB holds its monthly meeting tomorrow. Below we look at the main topics of discussion, with the ECB weighing some important decisions.

Could the ECB cut its main interest rate again?
  • Possibly. It is certainly considering it. As with last month, growth and inflation have remained subdued, providing further incentive and scope for the ECB to cut rates.
  • There has not been a significant downturn on either front however, meaning many do not expect further action.
The ECB is considering a negative deposit rate
Most reports suggest the ECB Governing Council is split on this issue. At the least this means it is unlikely to push ahead with it. We also believe the problems and complications outweigh the benefits. There has been much written about this but below we summarise the key points.

Logic: banks are now charged for holding large excess reserves (deposits) with the ECB, this will hopefully encourage them to make loans on the interbank market and make more loans to the real economy rather than holding the money at the ECB.

In favour:
  • Banks and investors look for higher returns and begin lending cross borders again. This aids financial integration and could help tackle other issues such as the large Target 2 imbalances.
  • Increases the amount of times money is circulated through the economy (the velocity of money) as lenders try to avoid getting stuck with excess cash. This could in theory help boost inflation and growth.
Against:
  • Contrary to prevailing logic it could actually cause a drop in liquidity. As excess reserves become more expensive banks begin repaying loans they have taken from the ECB. All the while they are deleveraging (may even speed it up), causing less money to flow to the real economy.
  • Rates could actually rise for a number of reasons. Larger number of weaker banks forced onto the interbank market. Banks may simply look to pass on increased costs to consumers.
  • If banks do not pass on costs or deal with them, then profits will be hit – in many cases they are already worryingly low.
  • Could increase the flood of money to safe assets, particularly from the core eurozone countries. The return on these would become even more negative, increasing their costliness and driving divergence with the rest of the eurozone.
  • The large money market fund industry, which plays an important role for liquidity in bond markets, could struggle to stay afloat since it relies on small positive returns on safe short terms assets (see above points).
  • The euro is likely to weaken, this combined with the other effects could cause a large outflow of cash to other parts of the world, exacerbating problems.
What about all the talk of boosting lending to small businesses?
This focuses around the creation of a new market for securitised loans to small businesses. The logic being: banks make these loans, package them together into securities and then sell them on to other banks and investors. There is a clear demand for quality assets which provide a decent return meaning there could be demand for such securities.

However, the ECB has backed away from grand plans on this issue. As we pointed out previously it was always very hesitant about purchasing such securities itself, with the Bundesbank in particular opposed to such action.

More of the same seems likely
With things ticking over the ECB is likely to hold off on any further drastic action at its meeting tomorrow. It will continue to emphasise that monetary policy will remain loose for some time (the concept of forward guidance which it began to adopt last month to some extent). It may also put more flesh on the bones of schemes to work with the European Investment Bank (EIB) to boost lending to small businesses. Some easing of the collateral rules as we predicted last month is also a definite possibility.

As we’ve said before, the ECB continues to look constrained. It does of course have a few more tools, however, they are in many cases quite extreme and have potential side effects. These are best suited to very extreme scenarios (euro break-up) rather than the wider malaise and long term endemic crisis which the eurozone now faces, particularly given that often (as we are now seeing with banking union) any ECB action sparks complacency and inaction on the part of politicians.

4 comments:

Anonymous said...

"The ECB is considering a negative deposit rate"

Does this mean the Bundesbank has to pay interest on the 700billion euros target2 claims it holds?

Not that I wouldn't expect such idiocy from the ECB, but it still might create a public outcry in Germany though.

Open Europe blog team said...

@Anonymous

Thanks for the comment. In fact, Target 2 liabilities are charged interest at the main ECB rate (currently 0.5%). This is paid by those with large liabilities (Greece, Italy, Spain) and transferred to those with large claims such as Germany.

Interesting, to note then that as the main rate is cut (as it was last month), Germany is actually receiving less interest on this claim.

christina speight said...

I don't feel that OE's reply actually answers the question! IF the ECB produces a negative interest rate then according to OE's answer Germany will Germany will actually receive negative interest on this claim.?

And in this respect OE's report today on the IMF document completely omits the criticism that it went along with the EU in constructing the Greek deal on the basis, not of Greece's welfare but of the future of the EU. In other words "The Greeks don;t matter - the Euro does"

Charming lot these eurocrats whom OE so assiduously backs.

Jesper said...

The monetary transmission system is broken in the periphery but it is not broken in the core -> A change in the monetary policy would impact the core directly but the periphery would be largely unaffected.

Changing the monetary policy would only create a credit-bubble in the core and the periphery would not see any benefits whatsoever of the loosened monetary policy.

While it is possible to get credit flowing in the periphery it is unlikely that those countries are willing to take the necessary steps:

-stronger creditor rights
-enforcement of creditor rights

Selling goods or services on credit in the periphery or lending in the periphery is higher risk than the same activities in the core. Higher risk -> higher cost (more reward for creditor)

Central planners will always ignore variations, market participants in a market economy will try (some succeed, some fail) to take exploit differences. The differences in creditor rights and enforcement of creditor rights goes a long way to explain the differences in cost of credit and availability of credit in the different countries in the euro-zone.