ECB acts as expected, now the waiting game begins

For anyone following twitter yesterday around the ECB’s announcement and press conference it would seem as if we have just had another ‘whatever it takes’ moment (when ECB President Mario Draghi promised to backstop the eurozone).

However, stepping back for a moment and it becomes clear that the ECB acted more or less as expected and some would argue has done the minimum necessary to retain its credibility and not be labelled an ‘all talk’ institution.

Sure, the package of measures looks more impressive when strung together but as we discussed in detail here and here, few if any of them address the crux of the problems in the eurozone which are depressing inflation and growth (delayed impact of internal devaluation, rebalancing of various economies, recapitalisation of banks and the breakdown of the eurozone’s cross border financial system).

All that said, there were a few more subtle and interesting takeaways from Draghi’s press conference.

Unanimous support is impressive but unlikely to apply to further easing
Draghi stressed that the support for this entire package of measures was unanimous. This is quite surprising given the previous Bundesbank opposition and does add weight to the strength of the decision. That said, just because unanimity was agreed here does not mean it can be easily translated into support for much stronger action such as asset purchases. In fact, Draghi’s hesitancy to talk about such a programme in more depth and the ECB’s willingness to push ahead with one suggests a lack of consensus on the issue. Furthermore, the outcry in Germany has already begun and will likely make central bankers think twice about stronger easing action.

Draghi insists the ECB is not “finished”, but its mighty close
Over the past year, Draghi has waxed lyrical about all the tools at his disposal and we have analysed them all in detail – see here. However, with this package of measures he has come close to emptying his toolkit – he admitted as much on the rate side saying that, for all “practical purposes”, the lower bound has been reached.

True, he has pulled out many of the smaller tools and retains the big sledge hammer of asset purchases (Quantitative Easing through buying either private assets or government bonds) but the bar to take such action remains high and gaining support for it remains a huge challenge. Pushing the deposit rate further into negative territory is also unlikely to work as banks will simply begin hoarding hard cash – this of course has some cost in terms of storage and security but it will not be more than a fraction of a percent. Finally Draghi stressed that this package could take some time to have any impact, between three and four quarters (9 – 12 months), suggesting that the ECB is now in wait and see mode as the emphasis falls on governments and the bank stress tests to help push along the economic recovery.

Impact of long term lending operations relies on cross border lending being revived
As the useful chart to the left shows (from Morgan Stanley via FT Alphaville) the amount which banks can borrow is again limited in countries which need it (the periphery) due to their already underdeveloped markets in lending to small and medium sized businesses. The technical structure for the TLTRO (pronounced Tel-tro) does allow for them to borrow more if they lend more but this will take some time. Ultimately, the target seems to be to encourage banks in the core to lend to banks and businesses in the periphery – this fits with the theory of the negative deposit rate which should encourage a search for yield. Rebuilding the cross border system in the eurozone remains a huge task.

Another potential question which arises is whether the end of sterilising purchases made under the Securities Markets Programme (SMP) will raise any legal issues or challenges in Germany and whether it will impact the judgement of OMT sterilisation.

In the end, the ECB has made its play and will likely now give it time to pan out. It will continue to provide dovish statements and may even talk up asset purchases in the future but it will urge patience in waiting to see if these measures have the desired impact.

ECB to ease policy but impact could be limited

Over on his Forbes blog Open Europe’s Raoul Ruparel provides a preview for tomorrow’s ECB meeting at which some action to ease monetary policy is expected.

In specific terms he sees the ECB taking the following action:

1. Cut the main interest rate to 0.15% (from 0.25% now).
2. Cut the deposit rate to -0.1% (from 0% now). This will be an unprecedented move.
3. Announce a new Long Term Repurchase Operation (LTRO) focused on boosting lending to small and medium sized businesses. The term of the LTRO will be between 3 and 5 years, rates will be reduced if banks provide evidence of a pick-up in lending (see below for a useful Nomura graphic on this).

It could also decide to end the sterilisation of the Securities Market Programme purchases, creating a liquidity injection of €164.5bn and loosen collateral rules further. The ECB will likely keep asset purchases (both of private assets and government debt) in reserve but will likely reiterate that such action remains possible as part of a broader dovish statement from Draghi.

Despite some of these moves being unprecedented Raoul forecasts that the impact could be limited. This is for three reasons. First, much of it has been priced in as the moves have long been expected. Second, the impacts of a negative deposit rate and targeted LTRO are far from certain. Finally because it does not address the key problem, as he notes:

As the chart below shows (courtesy of SocGen) the biggest problem facing the eurozone financial system at the moment remains the discrepancy in lending rates to businesses in different economies. The knock-on impact of this is limiting credit in countries where the economy needs it and where it is needed to help drive inflation and growth.

It’s not clear that the rate cut, negative deposit rate or the LTRO will help close this gap. Fundamentally this gap is driven by a few factors which these issues do not address:

• Banks continue to deleverage and overhaul their balance sheets. The ECB’s Asset Quality Review and the bank stress tests are in the process of trying to put banks on a surer footing but until they are all done and dusted this process will weigh on banks actions.
• Cross border lending system in the eurozone remains fractured. Banks and investors on the whole are still not willing to lend and invest heavily in the peripheral economies. This stops the excess liquidity in the stronger countries filtering in the weaker ones. While negative rates will seek to encourage such movement by pushing a search for yield it is unlikely to override concerns over risk and the desire for safe assets.
• As recent ECB bank lending surveys highlight the problem is not just on the supply side but also the demand side. The economic overhaul, reform and rebalancing on many of the eurozone economies (both in the core and periphery) is an on-going process. Not only does this itself limit demand but it highlights that lending must be to new sectors and new drivers of economic growth rather than helping to simply prop up older sectors (here I am thinking for example in Spain of lending to new services rather than to the old real estate and construction sector).

Has the ECB actually moved closer to QE?

There has been a cacophony of comments from ECB members and ECB watchers over the past few days. However, the overriding view since ECB President Mario Draghi’s press conference last week is that the ECB has now moved a step closer to unconventional action such as Quantitative Easing (QE).

This is mostly down to two factors. First the following statement from Draghi’s presser:

“The Governing Council is unanimous in its commitment to using also unconventional instruments within its mandate in order to cope effectively with risks of a too prolonged period of low inflation…this statement says that all instruments that fall within the mandate, including QE [Quantitative Easing], are intended to be part of this statement. During the discussion we had today, there was indeed a discussion of QE. It was not neglected in the course of what was actually a very rich and ample discussion.”

Second, the FAZ report over the weekend that the ECB has been modelling the impact of a €1 trillion per year (€80bn per month) QE programme. While it suggested that such a programme would only raise inflation by between 0.2% and 0.8% (not a significant amount given the cost), the simple fact it is being modelled has been enough to give markets hope.

We believe QE or similar measures have become a bit more likely, but mostly because the market now seems to expect action and if the ECB is to maintain its credibility it will need to do more than simply talk.

That said, while there may be ‘unanimous commitment’ to using such measures when needed, it’s still not clear what the criteria are for such action and it is even less clear that all members of the GC agree on when such action would be needed. Draghi was pushed on this on the first question during the Q&A session, however, he never provided a direct answer.

Furthermore, much of the coverage has suggested that QE is in fact closer because the ideological opposition to such a measure at the Governing Council (GC) level has crumbled - although we're not sure that such a clear unified opposition ever really existed.

With this in mind then, it’s worth once again pushing the point that, in fact many of the issues with further easing are practical, political and/or legal rather than ideological at the ECB. We have previously analysed each measure in detail, below is a summary and links to all those posts:

Quantitative Easing (purchasing government debt)
We have detailed the issues extensively here (but also here and here). Draghi has hinted of these practical issues before, highlighting that they need time to design the programme and gather more information. Beyond political opposition in Germany and the legal limits to ECB financing governments, there is a clear problem in that the purchases would need to split according to the ECB capital key, meaning little would flow to the periphery where the deflationary forces are strongest. Add onto this the fact that QE in other countries has not been proven to boost the real economy or even bank lending as well as that it may exacerbate the squeeze on safe assets and it becomes clear that practically and technically this would be a very difficult step for the ECB to take and is not well suited to tackling the problem of low inflation.

Quantitative Easing (purchasing private assets)
See our detailed analysis here. The thrust would be to target purchases of assets which would help promote bank lending – the main one discussed is Asset Backed Securities (ABS), particularly ones made up of loans to the real economy. However, these markets in Europe are small and underdeveloped meaning the level of assets available and suitable for purchase would be minimal. The ECB has suggested it wants this market to grow but it’s tough to force such a move, especially in the short term.

Negative deposit rate
We analysed this option here. Since then the ECB seems to have made progress on the technical implementation of such a move. That said, the impact remains very uncertain. It could further reduce excess liquidity, force money market funds to shutter and force banks to pass costs onto consumers. On the plus side it could help weaken the euro.

A targeted LTRO (similar the Bank of England’s Funding for Lending Scheme)
Discussed, with other measures, here. A fairly simply option to take, however, given that there is already full allotment (unlimited liquidity at low rates) and banks have already repaid a lot of the previous LTROs there is no guarantee there would be any significant take up or that it would filter through to the full economy.

Ending sterilisation of the Securities Markets Programme (SMP)
A smaller measure, discussed in this post. While it would stop liquidity being drawn out of the system on a weekly basis, it’s not clear that this liquidity would flow to the real economy.

Further standard measures such as rate cuts and changing collateral rules
We rounded up such options a while ago here. Given that rates are already so low and that the transmission mechanism remains broken, the impact of such moves is likely to be limited to signalling intent rather than hoping for any significant return.

Overall, nearly all of these measures face quite serious practical, technical and/or legal obstacles.

Furthermore, it is unlikely that there is any consensus at the ECB GC level of when each measure is needed or what the triggers for such action are. The obstacles are also probably viewed to be different sizes by each national central bank. All that is to say, while it may have moved slightly closer, don't yet count on QE being much more than a last resort.

ECB stands firm but looks to wider measures

Over on his new Forbes blog, Open Europe’s Head of Economic Research Raoul Ruparel lays out his take on why the ECB decided to stand firm despite the apparent deflation threat,

“My feeling is that there are two broad reasons. The first being that the flow of data is mostly positive, and the second, more important factor, being that none of its tools are economically, politically or legally suited to tackling the low inflation environment in the eurozone.”

He concludes,

“All in all then, the tools at the ECB’s disposal are far from suited to helping push up inflation in the struggling countries and boosting lending to the real economy to help economic growth. This is not to say the ECB would never use them, but that are better suited to a deeper more acute crisis (such as a break-up threat) than the chronic long term malaise which the eurozone currently finds itself in.”

These are themes we’ve explored plenty of times on this blog so won’t rehash here.

But there were a couple of other interesting points to come out of ECB President Mario Draghi’s press conference though.

The first being his mention of a new dataset which the ECB is looking at, specifically the “the high degree of unutilised capacity” in the eurozone economy. This refers to the ‘output gap’, i.e. the amount by which GDP in the eurozone has fallen below potential GDP. As you might imagine, estimating such a gap is fraught with difficulty and estimates are notoriously revised retrospectively (for example before the crisis few economies were seen performing above potential despite huge financial, real estate and debt bubbles).

Why is this important? Well, it could be the first step towards a more firm GDP target on the part of the ECB. Admittedly, it’s a small step and a full GDP target is unlikely but it could be an interesting shift for the ECB which has traditionally focused more on inflation, money market and private sector survey data (such as the PMIs). As Draghi himself said, it also shows that monetary policy will stay looser for longer, even if the data improves, due to the large gap between actual and potential GDP. It will be interesting to watch how this one develops over the next few meetings and whether the ECB decides to put any more emphasis on this measure.

ECB preview - ECB may take limited action but shy away from serious intervention

As we noted last month, a lot has been pinned on the March ECB meeting, with the release of new data potentially facilitating further easing action.

But on the eve of the meeting, analysts remain split, although the sense is that the pressure for significant action is easing. February’s inflation data came in above expectations, with core inflation (removing the effect of short-term moves in energy and food prices) actually at 1% - still very low but well above expectations. We’ve also seen positive PMIs (indicators of private sector business activity) across the eurozone and in some of the struggling countries, although France remains behind the curve.

With that in mind, it looks as if the ECB will shy away from taking a major decision on Quantitative Easing or a negative deposit rate. These remain drastic actions which the ECB is clearly unsure about, and with good reason. It’s not clear what the side-effects would be of such action or that it would actually feed through to tackling low inflation in the periphery or boosting lending to the real economy (and therefore economic growth).

There are a few other options on the table. Another, more targeted long-term lending operation (LTRO), or purchases of private sector assets, probably packaged bank loans (asset-backed securities). These are possible and more likely than the above, but for reasons discussed before, would also be quite a big step by the ECB.

The most likely options remain a token rate cut (i.e. one without an accompanying cut to the deposit rate), a further extension of the unlimited fixed rate liquidity provision and the end to ECB sterilisation of the Securities Markets Programme (SMP) bond purchases. We have outlined before that, at this stage, a rate cut makes little difference as the transmission mechanism is broken, at least to the areas where the impact of the cut would like to be felt. Extension of the liquidity provision is also broadly inferred and was always expected to go on as long as is needed, in line with the forward guidance given.

We’ve yet to discuss the end to sterilisation, so we lay out a few points below.

As a recap, the SMP was a programme launched in 2010 to purchase government bonds on the secondary market and bring down borrowing costs for certain countries (which were hampering the transmission of monetary policy). The sterilisation process sees the liquidity introduced by these purchases absorbed by the ECB, through the issuance of corresponding amounts of one week fixed-term deposits with an interest rate of 0.25%.

ECB SMP sterilisation total amount (€m)

Why take this measure?

• The idea is that ending the sterilisation would free up the €175bn in liquidity currently pledged to the ECB. This will counteract the recent decrease in excess liquidity in the eurozone and should encourage banks to lend this money out rather than simply posting it with the ECB.
• From a political perspective, this is also one of the least controversial actions since it has been endorsed by the Bundesbank and should be fairly easy to get support for at the ECB Governing Council.

Will it have any impact?

• It is unclear, but we are not overly hopeful. As the chart to the right (courtesy of Commerzbank) highlights, the earlier tensions in money market rates have eased. This means the impact will be limited.
• Ultimately, it depends on what banks decide to do with this money. The ECB deposits were a very safe investment with a decent return given the ultra low rates around at the moment. Our feeling is that banks will want to continue to search for equally safe assets rather than take on much more risk for a similar return over a short period. This could actually acerbate the demand for quality short term assets, particularly core ones, in the eurozone.
• Despite some failings in the sterilisation (shown by sharp deviations in the graph) demand has been fairly solid, although whether this is due to demand for safety or a decent return is unclear.
• The fixed-term deposits are also eligible as collateral for the ECB’s lending operations. It’s not clear if they have been used for this purpose, but if they were, this could further limit the impact in terms of boosting liquidity.

Ultimately, ending SMP sterilisation would be a token compromise measure. Its greatest use is probably as an indicator of an on-going willingness to ease if needed, and of the ability to compromise on the issue from the Bundesbank side. 

Are further falls in inflation putting more pressure on the ECB to act?

Friday saw the release of the flash estimate for annual inflation in the eurozone in January. It dropped further to 0.7% - well below the ECB’s target of 2%.

The initial reaction was that this will increase pressure on the ECB for action at this Thursday’s Governing Council meeting. While that is true on the surface its worth keeping another couple of points in mind.

• As the graph above shows (click to enlarge), much of the recent decline has come from changes in energy and food prices. Core inflation, excluding these two factors, has been relatively stable since October and has been on a gradual decline since spring 2013.
• Now of course, many will point out that energy and food are important components of real world costs and therefore should not be discounted. This is a valid point, but here we are looking for insight into how the ECB takes its decisions. Generally, the ECB will be less concerned over short term moves in energy and food prices and is therefore less likely to take action off the back of this.
• The main part of the decline took place last year and has been happening for some time – this is likely already accounted for in the ECB easing efforts.
• While the inflation data may not push the ECB to act, there are plenty of other concerns. The turmoil in Emerging Markets could push the ECB to provide an additional liquidity buffer against any shocks. While this morning’s PMI manufacturing data was actually very positive for the eurozone, data on lending to the real economy and growth of the money supply is less so.

As we have suggested before, some further easing is looking likely. The real question is when and how? The data suggests to us that the ECB will wait until its March meeting and its updated inflation forecasts to make a judgement – but then again it went a month earlier than expected in November.

As for how, the most likely tools remain some form of targeted LTRO and/or purchases of bank loans but both programmes would require significant work and have numerous shortcomings, as we have already noted.

A peek inside the ECB’s toolkit

Despite being barely a month into 2014, there have already been countless column inches written about the ECB and President Mario Draghi’s potential actions during 2014 (mostly to tackle the ‘deflation ogre’).

Is the ECB toolkit empty?

As we have noted before, while the ECB has an extensive toolkit in the case of an acute crisis, it has so far struggled to find the right tool (if one exists) to help promote lending to the real economy and therefore economic growth.

The favoured policy, widely cited by commentators and mentioned by Draghi previously, is some form of targeted liquidity scheme linked to lending to the real economy – along the lines of the Bank of England's 'Funding for Lending' scheme.

Such an option remains possible, but as Bundesbank Chief Jens Weidmann has pointed out, difficult to implement. We have noted this before, but, given that the ECB is already running unlimited liquidity at near zero interest rates (on loans up to three months) it’s hard to see that there would be huge demand for longer loans tied to specific lending requirements.

Over the weekend, speaking at the World Economic Forum in Davos, Draghi revealed another potential policy – ECB purchases of bundles of bank loans (aka. securitised bank loans or asset backed securities).

Is this a real option?

• The ECB has previously purchased covered bonds and government debt on the secondary market. Hence, securitised bank loans should be possible in theory.
• However, as Draghi himself admitted, the market for such securities remains seriously underdeveloped in the eurozone.
• The idea seems to be in its early stages, and probably requires a lot more discussion within the ECB.
• The move would likely face significant opposition within the Bundesbank, and Germany more generally. This would probably be focused on the risks involved in such asset-backed securities, which are often opaque and continue to have a negative connotation due to their role in the financial crisis.
• These are the reasons why Draghi has previously shied away from direct action in this area, instead suggesting that it is an area for the European Investment Bank (EIB) to act. There have been comments suggesting that work was underway on a joint programme, but nothing ever emerged.

Would it be effective?

• At the moment, no. The market remains significant underdeveloped. According to the Association for Financial Markets (AFME) the outstanding securitisation market is €1,545bn - only €131bn of which related to small business loans, while the very large majority of which relate to Retail Mortgage Backed Securities (RMBS) probably from the UK and Netherlands. While Draghi is probably right in his suggestion that it would develop in response to any ECB action on this front, it has a long way to go.
• Data from AFME give some flavour for the securitisation market in Europe. As the tables below show, the market remained small over the past few years, with less than a fifth of last year’s issuance relating to lending to Small and Medium-sized Enterprises (SMEs).

• Furthermore, in terms of the location of collateral, the markets remain very underdeveloped in the countries which the ECB would likely want to target. The UK and Netherlands account for a large chunk of the European market. Italy and Spain do have some market presence, but it remains small compared to the size of their economies (although this is true for the sector in general).

• The final point to note is that the structure for such securities remains opaque and undefined. Given that they are bundles of various technical products, they will always be difficult to value, and while credit rating agencies have improved their processes, questions will still be asked as to whether their ratings truly reflect the risk and value of these products.

While this option looks to be some way off then, the fact that Draghi felt the need to bring it up will likely encourage the view that the ECB will take some further action in the coming months.

ECB preview – ECB edges towards rate cut as inflation drops

Interest has grown in this month’s ECB meeting, after inflation surprised on the downside last month, falling to 0.7% - far below the ECB’s 2% target.

In all likelihood, the discussion will not be too different from previous monthly meetings, but there are a few points worth flagging up.

A rate cut in November or December?

• The consensus is now moving towards a rate cut this month, or more likely next month. As we pointed out before, this will have little impact given that rates are completely detached from the ECB’s main interest rate and the transmission mechanism remains broken in much of the eurozone. Ultimately, it is a signal that the ECB is keen to keep loose monetary policy. 
• The ECB, though, could well hold back for a few reasons. Firstly, it probably wants to see how the nascent recovery in the eurozone develops. Secondly, it knows this is probably its final rate cut and wants to time it correctly. Thirdly, its medium-term forecast is for inflation to recover (although this is likely to be revised downward in December). 
• FT Alphaville also highlights the interesting point that, given that this will likely signal the end of rate cuts, the response could even be a slight increase in market rates.

A new LTRO in the New Year?

• The shrinking of the ECB balance sheet continues, as eurozone banks are repaying the LTRO loans. Liquidity is dropping rapidly in the eurozone and short-terms rates have edged up somewhat – creating a de facto tightening of ECB policy. This is exacerbated by the continued easing bias by the other global central banks.
• That said, the previous LTROs have served to increase the sovereign-banking loop. They also remain a blunt tool since the amount of liquidity injected relies on demand, while the prospect of this lending being stigmatised under next year’s stress tests could discourage banks from tapping it.

Euro strength weighs on the ECB’s mind

• The strength of the euro in recent weeks, particularly against the dollar, has been covered widely with an increasing number of investors and politicians calling for action on this front. 
• Although the ECB has stressed that it does not target the exchange rate, it has shown before that it certaintly considers it. Draghi has shown a willingness to ‘talk down the euro’ previously, and is likely to try and do so again. However, turning this into lasting success is tricky and clamour for more concrete signs could increase.
• Failure to address the issue also leaves the currency open to volatility, as markets struggle to interpret the ECB’s vague signals and balance them with more defined ones from other central banks.

What to do with the deposit rate?

• This is another aspect weighing on the ECB’s collective mind. As we pointed out before, a cut to negative territory could have many unintended consequences, and is unlikely to be risked in anything but the worst circumstances. Still, the desire to maintain some ‘corridor’ between the regular rate and the deposit rate could make the ECB think twice about cutting rates at all.

As the above suggests though, we stick by our view that the ECB does have limited tools to help promote economic growth. This meeting is also likely to be another test of its new communication policy and whether it can really have lasting market impact. Ultimately, though, pressure for some concrete action from the ECB is likely to increase as long as inflation remains subdued.

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.

ECB increasingly likely to cut rates but running short of tools to help the eurozone economy

The ECB looks set to cut its main interest rate by 0.25% to 0.5% on Thursday (while keeping the deposit rate at 0% due to concerns about distortionary effects of negative rates).

Why is the ECB considering cutting rates?

• The obvious answer is that the crisis is clearly dragging on and the eurozone economy is struggling. But, that has been true for some time, so why now?
• Economic activity has been particularly bad (see right hand graph below), while forecasts have been continuously downgraded.
• In particular, annual inflation has dropped well below the ECB’s target of 2%, while unemployment has continued to rise (left hand graph below, click to enlarge).

Will it have any impact?

• Not really. On the margin it will help reduce costs for those banks which borrow heavily from the ECB and consumers with variable rate loans and mortgages – but the impact will be very limited.

• The usual mechanism through which a rate cut is transmitted to the market is broken. See for example the overnight lending in the eurozone. It remains at a very low levels. That said, rates are also at record lows. Why is this? Well, most likely because only the strongest banks are borrowing on these markets. For this reason the cut will not filter through to where it’s most needed since lending rates are already completely detached from it and focus more on the risks of the banks involved.

• As has been well documented, rates in the south and the north are also significantly different, particularly in terms of lending to businesses. Clearly, these have also diverged from the current ECB rates which are already incredibly low. Cutting further is unlikely to impact this.

What other tools does the ECB have?

Communication: ECB indicates willingness to keep monetary policy loose and step in to aid markets if needed. This has been used effectively by the Fed.
Probability: High, especially in coordination with rate cut.
Effectiveness: Minimal boost since it is already being pursued to some extent, more to reassure markets.

Easing collateral rules: ECB widens the range of assets which it accepts as collateral in exchange for its loans. May also decrease the 'haircut' applied to the value of the loans (thereby increasing their worth as collateral). This is likely to be targeted on SME loans and securities made up of SME loans.
Probability: High, if not this month then in June, particularly if economic data continues to be poor. Effectiveness: Limited, could help bank funding but unlikely to boost SME lending significantly. More risk taken onto ECB balance sheet, likely to widen divisions with Bundesbank. Has been done previously and had little impact.

Outright purchases of SME loans and securities: ECB purchases securities of bundled SME loans, similar to the purchases it made under the Covered Bond Purchase Programme and the Securities Markets Programme.
Probability: Very low. Draghi has previously suggested he sees it more as the job of institutions such as the EIB to help SMEs. Furthermore, the level of SME ABS is limited since they rely heavily on bank loans for funding (another reason why the ECB believes a rate cut could help, at least in theory).
Effectiveness: Limited, especially given that the market for such products is not huge. It would also increase the risk taken directly onto the ECB balance sheet (more so than easing collateral) and would provoke an outcry in Germany for overstepping the acceptable level of central bank intervention. Furthermore, such direct purchases are much harder to unwind than loan related policies which expire naturally, selling off these assets will be tough.

A version of the UK 'Funding for Lending' scheme: not really an option for the ECB at this time, contrary to popular belief. The various national regulations and structures aside it is practically impossible since the ECB already applies full allotment (unlimited lending).
Probability: Very low.
Effectiveness: Potentially counterproductive as the ECB would need to end its programme of full allotment in order to then make liquidity dependent on the amount of loans made by banks.

These are to name but a few options being reviewed currently. Other options such as working with the European Investment Bank to promote SME lending would need political assistance, while options such as 'Quantative Easing' aren't viable for the ECB, as we discussed here.

So for all the talk of the rate cut, it will likely have a very minimal impact. The ECB could look to combine it with other policies but the painful reality is that, when it comes to boost lending to the real economy, the ECB has very few options. Constraints from the Bundesbank and concerns over the progression to banking union mean the ECB will likely continue to put the onus on governments to make reforms to boos the economy.

Another tricky morning for the eurozone

It’s been a somewhat less than pleasant morning for the eurozone. Firstly, the European Commission put out its latest economic growth forecasts, which do not make great reading for many countries. Here is a comparison between the EC's forecasts and the latest national government forecasts for growth:

As the table shows, there is a long list of countries which seem to be overestimating their growth for this year including: Italy, France, Spain, the Netherlands and Ireland.

We expect to see a series of growth revisions throughout the year on the part of national governments – in some cases such as Greece, we expect that the Commission forecasts will also prove overly optimistic (notably the figures used in the Greek budget are actually below the Commission forecasts). The figures also highlight the growing cracks in the Franco-German axis as the two countries diverge economically; this was reinforced by the starkly different PMI (business activity) figures yesterday.

The implications of these inflated growth projections are also becoming apparent. Nowhere is this clearer than in Spain, where the Commission highlights that, without additional measures, the Spanish government deficit in 2013 and 2014 will be 6.7% and 7.2% of GDP respectively. This compares to targets laid down by the eurozone of 4.5% and 2.8% respectively.

The Commission’s estimates of Greek unemployment also still seem unrealistic, at 27% and 25.7% in 2013 and 2014. In November 2012 unemployment reached 27% in Greece, according to the Greek statistics agency. With plenty of structural reforms still to go we expect this figure to increase further.

Secondly, the announcement of the repayment of the ECB’s second Long Term Refinancing Operation (LTRO) came in significantly lower than expected – 356 banks repaid €61.1bn compared to average expectations of €122.5bn. The steep slide in the euro exemplified the market response.

This highlights that underneath the recent optimism there is still significant fragmentation in financial markets and concerns over liquidity (as we have noted previously). Although impossible to tell conclusively, since these are just aggregate figures, we expect that many of the banks that have repaid were from ‘core’ eurozone countries, further exacerbating the differences between eurozone countries.

If you are looking for a silver lining, it could be that the rise in the euro has been halted for now, which may aid the competitiveness of the weaker countries, and that a potential de facto tightening of monetary policy has been avoided - this could have been a concern if banks repaid the LTRO and deleveraged rather than investing the collateral elsewhere.

The picture emerging from this morning’s data, then, continues to be a bleak one for the eurozone thanks to stalling growth across the bloc and banks hanging onto ECB liquidity. Beyond the headlines though, there is evidence of growing divisions as some of the core countries post growth and their banks repay ECB funding while peripheral countries find themselves in economic decline with banks surviving on ECB money but lending little.

A vote of confidence? Banks start repaying ECB long term loans

This morning saw the start of the on-going process of repayments of the loans given by the ECB to European banks under the Long Term Refinancing Operation (LTRO) (see here for details).

The ECB announced that 278 banks have already pledged to repay €137.2bn. This compared to the 523 banks in total that borrowed around €190bn in net liquidity from the first LTRO at the end of 2011. The amount repaid was above expectations – below we assess why this may have been and what it could mean for the eurozone.

Why have banks decided to repay so much so early?

- A big motivating factor is reputation. It is clear that banks which repay early can highlight that they have access to market funding at low levels and have a sustainable business model.

- Although the loans seem cheap with the low ECB rate they require lots of collateral (to which haircuts are applied). This cost mounts up and some banks (particularly in northern countries) can now borrow on the markets more cheaply. ECB funding is also secured (against the aforementioned collateral) this ties up lots of banks assets, many may prefer to seek unsecured market funding, even if it is a bit more costly.

- Having huge amounts of excess liquidity just parked at the ECB is not efficient or effective. It also distorts bank balance sheets and may detract from other goals such as deleveraging or recapitalisation (more on this in a minute).

What does this mean, if anything, for the eurozone?

- There are fears over a two-tier banking system between those stronger banks funding themselves on the market and those reliant on the ECB. We would add that this furthers the divergence in the eurozone since the split is broadly along the existing strong/weak country divides.

- If the move is to aid banks in deleveraging this could perversely have a negative effect on the eurozone, with banks decreasing lending and reducing demand for euro (particularly peripheral) assets.

- That said the net impact on liquidity is limited, with excess liquidity in the system still at almost €700bn. It may need a further €200bn to be removed before the impact is substantially felt in terms of borrowing costs and demand for assets in the eurozone.

- There could well be a confidence boost from the higher than expected repayment. However, if this furthers a strengthening in the euro there could be growing concerns that it could begin to hamper exports in the weaker economies (a key driver of growth when both public and private sector are limited spending). This also furthers tensions within the one-size-fits-all monetary policy.

So, there are some clear reasons for repaying the loans early, although what it means for the eurozone and the impact it could have is far from clear (this is partly because the actual impact of the LTRO beyond helping banks fund themselves is far from clear). 

One more thing: many analysts are now making a song and dance about the reduction in the size of the ECB balance sheet - seeing it as a great positive. Which it is of course. But strangely, the same people always made the point that the ECB's expanding balance sheet, really wasn't that importance. So which is it?

In any case, as we said at the start, this is a rolling process and the full impact will not be clear for some time. The most important point to watch now is the location of the banks which announce that they have repaid. If it turns out to be solely northern banks, we could see some divergence emerging in the banking system, at just a time when eurozone 'bank union' plans are trying to unify it.

IMF weighs in on the debate surrounding the ECB

There’s been another interesting report put out by the IMF today in the form of its ‘Article IV consultation on the euro area’ (essentially an economic assessment of the eurozone).

The IMF was particularly vocal on the role of the ECB stating:

“Because inflation is low and falling, the ECB has room for lowering rates, and deploying additional unconventional measures would relieve severe stress in some markets.” 

They’re not wrong there, any conventional inflationary pressure for the eurozone as a whole is definitely abating. But the policy implications of such a move are important. The IMF itself puts forward some alternatives, including:

Further liquidity provision. This could encompass additional multi-year LTRO facilities, coupled with adjusted collateral requirements, if needed—including a broadened collateral base and/or a lowering of haircuts—to address localized shortages. The associated credit risk to the ECB would be manageable in view of its strong balance sheet and high levels of capital provisioning. Nevertheless, one of the disadvantages of the LTRO facility is that it tends to strengthen sovereign-bank links (see Box 5).

Quantitative easing (QE). The ECB could achieve further monetary easing through a transparent QE program encompassing sizable sovereign bond purchases, possibly preannounced over a given period of time. Buying a representative portfolio of long-term government bonds—e.g., defined equitably across the euro area by GDP weights—would also provide a measure of added stability to stressed sovereign markets. However, QE would likely also contribute to lower yields in already “low yield” countries, including Germany. 

As you’ll notice both recommendations come with clear caveats – strengthening the sovereign banking loop with the LTRO and the fact that QE would need to be spread across the entire eurozone. We’ve discussed both at length on this blog and in our research but a refresher never hurts.

The LTRO has certainly driven the sovereign banking loop much closer, engraining this connection at the heart of struggling economies (far from ideal) while encouraging the nationalisation of financial markets once more. All this prompted the well-known and incredibly complex banking union discussion. The IMF also notes a further problem with more LTROs, asset encumbrance. A complex issue but essentially banks are running short of quality assets to post as collateral to borrow from the ECB (see graphic below). So even if further LTROs were offered they may not be able to take advantage of them. If the ECB went down this route and faced this problem it would have little choice but to widen its collateral rules or reduce the valuation ‘haircuts’ (which decide how much banks can borrow against certain collateral) thereby taking even greater amounts of risk onto its balance sheet.

 
In terms of QE we’d point you to our report from December and the table below. Ultimately, it would have to be a huge spate of QE to provide enough of a boost to the countries in trouble, but that would also create a huge amount of money flowing into countries such as Germany (which is already concerned about an asset and property bubble).

We’ve argued before that a more significant role in the crisis for the IMF wouldn't be the worst thing in the world. Generally it has provided a more realistic assessment of the situation. Unfortunately, in this case, the problems outlined above are only the technical ones relating to a greater role for the ECB, the political obstacles remain almost insurmountable in the short term. As with the UK government, we’d recommend the IMF engage but avoid spending too much time of policies which are politically nearly impossible and technically challenging.

The ECB loads up on PIIGS exposure

Reuters MacroScope blog covers some of our updated figures on the exposure of the ECB to the struggling peripheral countries. Following the ECB’s Long Term Refinancing Operations (LTRO) the ECB’s exposure to these countries has increased significantly, without their situations showing any sign of improvement – in fact many of them are now in a worse position.

Last year we showed that the ECB exposure to the PIIGS totalled €444bn. Just a year later this has increased by a whopping 106%, to €918bn. The exposures are detailed below:

Total exposure - €917.61bn 

Exposure through lending programmes - €703.61bn 

Greece - €73.4bn
Ireland - €85.07bn 
Italy - €270bn 
Portugal - €47.54bn 
Spain - €227.6bn 

Exposure through the Securities Markets Programme - €214bn 

This gives the ECB a massive leverage ratio 38.4:1. This in itself is not the issue, more concerning is the fact that a third of the ECB’s balance sheet now resides in the PIIGS.

On top of this, while the ECB’s exposure has been rising the quality of collateral supporting this exposure has been deteriorating quickly. There are a few factors underlying this:

 - The value of the huge amount of PIIGS sovereign bonds which PIIGS banks hold has fallen while the default risk involved with them has risen quickly.
- The sovereign guarantee which backs up many of these banks (both explicit and implicit) has also become less solid as the states’ finances worsen and public outrage against bank bailouts increases.
- The risks and losses held on the balance sheets of these banks is yet to be fully acknowledged or fully realised in many cases. (For example, see our recent briefing on the massive problems in Spanish banks relating to their exposure to the bust real estate and construction sectors).
- The ECB has widened its collateral scope allowing even more opaque and harder to value collateral to be used to bank up its unlimited liquidity provision. 

That is to name but a few of the issues in play (we'll have a fuller discussion of the implications of this next week).

The real question which should be asked in all this is: how has the eurozone crisis continued to worsen despite the ECB more than doubling the money it has poured into these states?

Patently, the current approach to the eurozone crisis has failed. Even the ECB’s massive interventions only bought a short amount of time (and a lot less than many may have expected). The eurozone continues to fiddle at the edges of the crisis. All the talk of ECB lending, eurozone firewalls, IMF resources and austerity programmes fails to accept some of the fundamental flaws which underpin this crisis.

The eurozone needs to accept that there are a few structural flaws underpinning the eurozone crisis and move to correct them, not least: an endemic lack of competitiveness in the peripheral states, a structural bias towards low growth, a massively undercapitalised banking sector, mismatched monetary policy and a currency which remains grossly overvalued for many of its members. Until these issues are tackled, with both widespread political and economic will even further sprays of ECB liquidity will do little more than buy time, while further raising the cost of the potential break-up.

Update

The figures on exposure through lending programmes were obtained from the websites of the national central banks of:

Greece
Ireland
Italy
Portugal
Spain

What is cheap ECB liquidity actually solving?

The ECB held its second three year long term refinancing operation (LTRO) this morning. Overall 800 banks requested €529bn in funding. The market and wider reaction has been mixed – the amount was well within expectations although the number of banks was much higher (up from 523 last time). The larger number of banks is widely being seen as positive since it suggest smaller banks took part this time - and they are more likely to lend directly to businesses - while on average banks asked for less liquidity.

The more important figure though, is how much of this is new liquidity. Of the previous €489bn LTRO only around €200bn was new lending, since banks rolled over their previous loans from shorter ECB lending operations. In this instance (since many loans have been rolled over) the new injection of liquidity is likely to be much higher. We expect that the new liquidity totalled between €300bn and €400bn.

Short term loans issued by the ECB earlier this week totalled €134bn, while €150bn of short/medium term lending is also due to expire this week - both can be seen to give an indication of the amount of lending which will be rolled over. Much of the new lending will have come from the loosened collateral requirements (€200bn or so) as well as the decreased ‘stigma’ associated with banks which borrow from the LTRO.

We’re yet to see a full list of who borrowed what (and probably won’t for some time) but there are some details (we’ll update as more come through):

Intesa Sanpaolo (IT) - €24bn
Lloyds (UK) - €11.4bn
Allied Irish (IR) - Unknown
Banco Popolare (ES) - €3.5bn
KBC (BE) - €5bn
Unicredit (IT) - <€12.5bn (not that this helps pin down the figure much)
BBVA - Similar to first LTRO (around €11bn)

Italian banks are reported to have tapped the LTRO for around €100bn in total, while banks such as ING (NL) and ABN Amro (NL) have stated that they did not tap the operation at all. Clearly 'stigma' is not an issue in Italy but alive and well in the Netherlands, presenting an interesting microcosm of the problems facing these countries.

One point we’d note is that the first LTRO was not tapped heavily by banks from the bailed out countries. There is no evidence that banks from Portugal or Greece took any ‘new’ lending from the first LTRO while Irish banks only took an additional €5bn (% of their current borrowing from the ECB and Irish central bank). This could be for one of two reasons: the banks are more or less blocked from taking on massive amounts of extra liquidity since they should be leveraging and meeting stringent capital requirements under the bailout programmes. Or, the banks in these countries had run short of collateral to post with the ECB in exchange for loans. It will be interesting to see if this problem held true in the second LTRO, given the loosened collateral requirements – early indications with the Portuguese borrowing costs jumping suggest it will.

This shows how the LTRO will not solve any of the eurozone problems. In fact it may not even help sentiment or lending in the worst hit countries. The Italian and Spanish banks look likely to increase their purchases of their domestic government debt, further intertwining eurozone states with their banking sectors. The question now is, how many more LTROs will there be?

Given the lack of a credible solution to the problems in Greece and Portugal we fear more may be on the horizon.

Ps. For you German speakers, it's well worth reading this piece from Die Welt's Holger Zschäpitz on why the LTRO is turning the ECB into a lender of first instance rather than one of last resort

UK banks and the ECB – part 2

We'll get back with a take on today's €529 bn of loans by the ECB to 800 banks, via the so-called LTRO, soon.

But first, something different. Remember, we've long been critical of the ECB's backhanded QE, which has created a range of zombie banks in weaker euro economies (reliant on ECB funding to survive). See here, here, here, here, here and countless other examples of when we're looked at this issue. So it's odd that we're now literally taking the 'oh it's not so bad' view in a discussion about whether the ECB is 'bailing out' banks. Well, at least UK banks.

This after the Left Foot Forward blog claimed, and then re-stated, that "the EU" is bailing out UK banks, after Loyd's (now confirmed) and possibly RBS (unconfirmed) accessed funding from the LTRO 2 (see here for background on this issue). We still do not see how this constitutes a 'bailout'. Again, these UK banks are merely saving cash through avoiding an extra exchange rate charge and borrowing at cheaper rates, rather than relying on more expensive (but still available) sources of funding. While the money will only be used to fund their European operations. This just isn't a 'bailout' in any sense of the word.

The Left Foot Forward provides a politically interesting interpretation, but, we believe, also misunderstands some crucial points:

- If it amounts to a bailout, it's a contender for the smallest one in history. €15bn (if that's the final amount) is equivalent to a tiny amount of the UK's banking sector, the assets of which amount to numerous times the size of UK GDP (around £1.5 trn). €15bn is hardly the difference between life or death for UK banks and surely not enough to signal the need for a complete change in approach.

- Lower collateral requirements are not directly tied in with the LTRO, as the Left Foot Forward blog suggests. It's a separate policy (just announced at the same time), but was not in place for the first LTRO, so to claim this is the whole motivation for the LTRO is a misnomer. It may allow UK banks to use assets which may not be accepted elsewhere, but is that enough for it to be considered a bailout? The only instance where this association would work is if UK banks had already used all other collateral worthy assets to gain liquidity - this simply is not the case. In fact the main choice for UK banks is whether the reduced cost is enough to offset the negative 'stigma' of using the LTRO.

On the wider point about QE style interventions, the blog is also confused. Does it want a UK LTRO or lower collateral requirements or both and would this be instead of QE or on top of it?

- Here we would say that the BoE already did its (more direct) version of the LTRO with the Special Liquidity Scheme and its ‘Quantitative Easing’ (QE) programme. It's still overshooting its inflation target by some way, throwing more liquidity into the system seems impractical and risky.

- Furthermore, money in the system has increased steadily in both Europe and the UK but lending has not, which is a problem. But increasing liquidity will not solve this. As results from January show, lending in the eurozone still fell despite the December LTRO. It fell by less than the previous month but still not a resounding victory for the theory that the LTRO is a clear cure to all the lending problems in the wider economy.

We could go round and round discussing the intricacies of the problems facing banks in Europe but ultimately there are endemic structural problems which cannot be solved by simply throwing more liquidity at the problem - in either the UK or the Eurozone.

The grass is always greener: UK banks, the ECB and the LTRO

We'd figured this one would cause confusion once a paper reported on it.

This morning’s FT noted that RBS and Lloyd’s are considering borrowing from the ECB’s long term refinancing operation (LTRO). Remember, the LTRO is the ECB's 'bazooka' response to the eurozone crisis, giving banks across the eurozone access to very cheap long term credit (aimed at avoiding a deep freeze in the banking system, e.g. banks stop lending to each other, which in turn could cause sovereign debt market drying up = Bye Italy).

That banks in Britain - a country that has refused to participate in euro bailouts - now ask for cash from the ECB looks pretty bad on the surface. At least for those not familiar with the ins and outs of central bank financing. And sure enough, the Left Foot Forward blog suggests that the ECB is now “bailing out” UK banks.

Hmmm, not quite.

First, this is actually not new. RBS (€5bn) and possibly HSBC accessed the first LTRO back in December when there was little furore over the process and there has been little fallout since.

But more importantly these banks are providing collateral and borrowing under standard repurchase agreement (repo) terms. Their reason for doing this is not because they cannot borrow this money from the Bank of England or because they could not survive without it - which the Left Foot Forward blog and some others seem to believe - but simply because it is a cheap source of euros. These banks have extensive operations and exposure to the eurozone and therefore it makes practical and economic sense for them to tap the ECB’s lending operations if possible.

All the ECB is doing is taking on the exchange rate risk for these banks (similar to the US dollar swap line – see here for our analysis of this). These banks could obtain this money in pounds and then change it to euros, but then they would have to incur the cost of the transaction and hedge against the risk that the exchange rate could shift significantly over the period of the loan. The UK government or the Bank of England (BoE) could’t really fulfil this role, unless it set up a direct swap line with the ECB (which is redundant since these UK banks can borrow from the ECB directly through their subsidiaries – as they are doing).

In other words, this does not represent any extra risk for the UK or eurozone governments (since collateral is posted) or any failing on the BoE’s part, but simply the subsidiaries of the banks making a practical decision about how to help fund their exposure to the eurozone. Now, there certainly are problems with the LTRO and the risks it poses for Europe's taxpayers in the eurozone long-term. If anything, it would be more concerning if taxpayer-backed banks did not seek to obtain funding at a lower comparative cost and cover their exposure to the eurozone crisis, given that the move is risk-neutral.

We would note the irony in that some in the UK are calling for ECB style unlimited three year lending to banks, while many in the eurozone are calling for UK style ‘Quantitative Easing’ – we guess the central banking grass is always greener…