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.

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.