Reviewing the borrowing costs of European nations, a visiting intelligent alien may conclude that the European economic crisis is over and rehabilitation complete.
10-year government bond rates for Spain, Portugal, Ireland and Greece are 2.20%, 3.12%, 1.67% and 6.15% respectively. Equivalent rates for Germany, France and Italy are 0.97%, 1.31% and 2.39%. Comparable rates for the US, UK, Canada and Australia are 2.53%, 2.47%, 2.17% and 3.56%. A little over a year after requiring a bailout, Cyprus returned to bond markets in June 2014 with a €750 million 5-year bond at 4.85%, which was substantially over-subscribed. As was the case before 2008, financial markets are treating Euro-zone as largely homogenous, ignoring the vastly different risks.
European rates do not reflect fundamental factors, merely the effect of massive liquidity injections from the European Central Bank (“ECB”). But as amply illustrated by the problems of a small Portuguese bank Espiritu Santo, economic and political risks are increasing.
The recovery from the recession remains weak and uneven as between member nations. 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 repeated willingness to act, on 5 June 2014, the ECB announced a series of measures designed to counter identified problems.
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 and Euro-system. Specifically, it will apply to banks’ average reserve holdings in excess of the minimum reserve requirements, government deposits held with the Euro-system exceeding certain thresholds and participants’ TARGET2 account balances.
The ECB ended sterilisation of Securities Market Program (“SMP”) purchases, injecting around €160 billion into Euro-Zone money markets.
The centrepiece was a new, complex funding-for-lending scheme – the Targeted Longer Term Refinancing Operation (“TLTRO”). The ECB will finance up to 7% of bank loans to non-financial corporations. The cumulative total is three times individual bank’s net lending to the non-financial sector, excluding home loans. Assuming around €5.7 trillion of eligible assets, the TLTRO equals new funding of approximately €400 billion.
TLTRO loans will mature in September 2018. The loans will be at fixed rates of the prevailing MRO (main refinancing operation) rate plus 0.10%, equivalent currently to 0.25%. As with previous LTROs, banks have an early repayment option. Between March 2015 and June 2016, banks will be able to borrow additional amounts in TLTROs, via auctions conducted quarterly.
In addition, the ECB proposed purchases of Asset Backed Securities (ABS”) to increase funding for businesses, although details would be worked out in the future.
The initiatives were designed to counter “lowflation”, increase supply of credit to create growth and weaken the Euro to increase European exporters’ competitiveness and counter disinflationary pressures from a strong currency.
European optimists believed that the ECB’s “monetary policy fireworks” represent a decisive turning point. Pessimists pointed to previous false dawns and ineffective policies.
The interest rate cuts were largely a technical exercise, having little impact on market rates. The easing of interest rates implied by the ECB’s initiatives is illusory. Using a Taylor rule approach, economist argue that , German interest rates, based on its domestic conditions, should be around 4.65% but would need to be around minus 10.75% for Spain or minus 19.25% for Greece.
The Danish experiment with negative interest rates suggests low efficacy, with limited change in monetary conditions. Negative rates act as a tax on banks, forcing them to lend rather than hoard cash. But with European banks’ deposits and reserves with the ECB at low levels, the effectiveness of the measure is questionable.
The TLTRO assumed there is demand for loans. With the strong likelihood that the Euro-Zone 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 and reducing balance sheets. This reflects the effects of the recession and new bank regulations. Banks’ ability to provide credit may also be affected by the ECB’s Asset Quality Review (“AQR”), which may require banks to write off debt and raise additional capital.
The previous two LTRO rounds saw ECB funding used primarily to finance governments. Estimates suggest that as little as 5% went into the real economy. The TLTRO was designed to provide low cost funding to businesses, especially small and medium sized enterprises (“SMEs”) 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 funds. As European banks do not appear to have funding problems, forcing banks to lend TLTRO funds to the real economy may act as a disincentive to draw on the facility.
The TLTRO requires banks to demonstrate by April 2016 that their “net lending to the non-financial private sector” is greater than in the previous 12 months. If they fail to meet this test, they must repay the TLTRO funds borrowed. But the TLTRO appears to allow banks to use ECB funding for at least 2 years for any purpose, including purchases of government bonds or refinancing of existing LTRO loans at a lower rate.
In practice, the TLTRO may marginally increase availability of credit in the Euro-Zone. It is likely that the TLTRO will operate similarly to the earlier LTROs providing cheap funding for banks to buy government and corporate bonds. The low risk profit will boost bank profits rather than economic activity. The sharp rise in bank share prices reflects the stock market belief that this is the likely outcome.
Increased bank holding of government bonds also increases the dangerous feedback relationship between sovereigns and financial institutions, referred to as the “doom loop”. European bank holdings of sovereign bonds, primarily domestic government bonds, have reached 5.8% of total assets, a significant increase from 4.3% in January 2012. Italian banks hold 10.2% of their assets in government debt (up from 6.8% in January 2012). Spanish banks hold 9.5% of assets in government bonds (up from 6.3% in January 2012).
ECB purchases of ABS are unlikely to be effective in the near term because outstanding volumes are modest. Total issuance of European securitised assets were €251 billion in 2012 versus €1.55 trillion in the US. With a portion of outstanding ABS already committed as collateral in ECB repos, the available volume is limited. The ABS market is also small compared to the €17 trillion in outstanding bank loans.
This means that the ECB will need to incentivise banks to create them in the first place. But there are significant technical hurdles to creating a sizeable European ABS market in the near term. The ECB requires simple, transparent structures which may not be readily available in sufficient size to have the desired impact. In practice, these considerations dictated the emphasis on purchases of government bonds by the US Federal Reserve, the Bank of England and Bank of Japan.
In addition, the ECB’s encouragement of ABS issuance will face opposition from European banking regulators who are in the process of tightening regulations, including increasing the amount of capital to be held against these securities.
Importantly, the ECB initiatives did not entail a broad asset purchase programme of the kind pursued by other central banks.
In early September 2014, the ECB further cut rates. The main interest rate was cut 0.10% to 0.05% or the “zero-bound” in ECB President Draghi’s words. The deposit rate was reduced to -0.20 %. It was an acknowledgement that the June announcement had had limited effect.
Data indicated that many Euro-zone members were in deflation; prices in Italy were down to -1.6%, Belgium -1.5%, Spain -1% and France -0.4%. The ECB had also reduced its inflation forecast to 0.6 % for 2014, far below the targeted 2% level. Despite vehement denials, the additional measures was designed to force down the Euro, which had not declined as much as desired after the June announcement. The September announcement resulted in the Euro falling down to US$1.30, a 14-month low.
The September 2014 round of TLTRO auctions was also disappointing. The actual amount allocated was around Euro 83 billion, well below the market expectation of Euro 174 billion. The ECB’s original plan had been to use the September and December 2014 auctions to inject around Euro 400 billion in liquidity.
The ECB was forced to announce that it would be accelerating asset purchases under its previously announced program to bring its balance sheet back to the mid-2012 peak level of Euro 3 trillion. This would require injection of around Euro 1 trillion. It is difficult to see the ECB meeting its target, without launching a full scale QE program.
The reality is that the ECB’s actions are unlikely to have much effect on the real economy. While they will support financial asset prices, the measures are too little and too late to materially boost demand.
President Draghi’s speech was reminiscent of a statement attributed to former US Vice President’s observation: “If we do not succeed, then we run the risk of failure”. Perhaps, the advice of comedian W.C. Fields was more appropriate “If at first you don’t succeed, try again. Then quit. There’s no use being a damn fool about it.”
Rather than creating growth, increasing inflation and weakening the Euro, the ECB program is likely to have unintended consequences.
The ECB actions have reduced borrowing rates for Euro-Zone members. While making existing high debt levels more manageable, the falling funding costs removes incentives for reducing debt and undertaking structural reforms. The Italian government proposes to use the benefit of lower rates, estimated at around €10 billion over three years, to increase spending and relax fiscal policy.
In a candid speech at the annual Jackson Hole meeting of central bankers, ECB President Draghi repeated his willingness to use unconventional tools to try to drive growth and inflation. But he admitted that the lack of fiscal flexibility, in part due to weak government balance sheets, and lack of structural reforms are barriers to a meaningful improvement in economic conditions. Pointedly, he questioned whether governments had used the period of low rates and interest cost savings on sovereign borrowings to undertake necessary but politically difficult reform.
Expectations of further falls in the credit spread of Italy, Spain and previously vulnerable peripheral nations is driving purchases of their government bonds supporting the value of the Euro, at least in the short term.
A weaker Euro policy may also prove problematic in the medium to long term. Falls in the Euro may not trigger the hoped for rise in economic activity driven by exports. A high proportion of trade is conducted in Euro within the Euro-Zone itself, limiting the currency effect. Weak growth in export markets, such as the US and emerging countries, may limit the benefits.
The US, UK and Japanese experience suggest that monetary policy may not be able to increase inflation significantly, reflecting the effects of deleveraging by companies, households, banks and governments. Falls in the Euro may increase the cost of imported products driving higher inflation. But the erosion of real household incomes may reduce consumption limiting any pick-up in growth.
There are systemic risks. A weaker Euro entails pursuance of a ‘beggar-thy-neighbour’ policy, exporting Euro-Zone’s problems as well as goods and services. Retaliation through competing monetary easing or capital controls may defeat the ECB’s efforts to weaken the currency.
The ECB’s zero interest rate policy (“ZIRP”) encourages the use of the Euro as a funding currency in carry trades, with investors borrowing Euros to invest in high yielding currencies, such as Australian dollars, New Zealand dollars, Brazilian reals, Turkish lira and South African rand. Use of the Euro in carry trades artificially affects price behaviour, with price increases being sold by borrowers and every decrease finding support from investors. This negates the ability of authorities to achieve specific price levels. It also reduces volatility increasing the risk of future major market dislocations.
The ECB initiatives also do not address the fundamental problems of over-indebtedness and need for structural reforms. Maintenance or increasing debt levels is a curious solution to a problem of too much not too little debt, which lies at the heart of the European crisis.
With few exceptions, the May 2014 elections for the European Parliament saw rejection of existing policies emphasising austerity and debt reduction. In France, the ‘Séisme’, as Le Figaro termed it, saw Marine Le Pen’s Front National win in 73 electoral departments against President Francois Hollande’s Socialists two.
Europhiles argue that pro-European mainstream parties (centre-right, centre-left, liberals, Greens) won around 70 per cent of the parliamentary seats. The unwillingness of Euro-elites and officials to see the election result as criticism of policies which have not restored the health of real economy was noteworthy. Official acceptance of high unemployment, particularly youth unemployment, and shrinkage of economies (Italian GDP is still around 10% below pre-crisis levels) was striking.
The business as usual stance was evidenced by the unseemly imbroglio over the Presidency of the EU Commission. The election of former Luxembourg Prime Minister Jean-Claude Juncker highlighted deep differences within members. The spat may have longer terms effects, increasing the risk of a British exit from the EU (Brexit).
Euro-sceptics point to the significant gains by anti-Euro and anti-European integration forces. But the real risk lies in its effect on domestic politics and complex coalitions between nations at the European level.
Italian Prime Minister Matteo Renzi’s strong showing in the European elections has strengthened his position. In alliance with France, Greece and Spain, Mr. Renzi is seeking a relaxation in the previously agreed program for improving public finances and debt reduction and a new political agenda focussed on growth.
This has revealed internal problems within Germany’s governing grand coalition. The SPD, Chancellor Angela Merkel’s CDU partners, have aligned themselves with Italy and their supporters. While the differences are being ‘spun’ as presentational not substantial, the CDU risks being outflanked by the SPD and also the rising anti-Euro AFD in domestic politics.
The likely resolution, a typical Euro-Zone fix, is likely to be continued support for the stability pact, requiring (for most members an unattainable) 3% structural budget surplus and a debt/ GDP of 60%. Instead, there will be a change in interpretation and application. Likely changes include further extension in the time allowed to reach targets and the exclusion of investments designed to support growth from the calculation of the budget position. Classified as technical in nature, these changes highlight repeated cute accounting games, which have contributed to European problems and a refusal to face harsh truths.
There continues to be legal uncertainty around many initiatives. In Portugal, the Constitutional Court has rejected a number of measures to pare back spending and benefits to the annoyance of the Portuguese government and EU officials. More recently, there is a new challenge to the Banking Union before the German constitutional court.
The significant shift in European politics increasingly attenuates growing economic risks.
In reality, the ECB program is a further tactical bluff in the long European poker game. ECB President Mari Draghi is increasingly reliant on influencing market sentiment to buy time, in the hope that growth, inflation and some structural reforms restore the Euro-Zone’s fortunes.
Mr. Draghi’s July 2012 statement that the ECB would “do whatever it takes” helped stabilise money markets and reduced sovereign borrowing costs without requiring any actual intervention. Mr. Draghi has continued to follow the strategy.
In October 2013, he was ready to consider all available instruments. In November 2013, there were a whole range of instruments that he could activate, if needed. For absence of doubt, in December 2013, he reiterated that he was ready to consider all available instruments. In January 2014, he would take further decisive action if required. In February and March 2014, he vowed to take further decisive action if required. In April 2014, the ECB President undertook to act swiftly if required. In May 2014, he repeated that he would act swiftly if required.
Announcing the 5 June 2014 initiatives, Mr. Draghi told reporters: “Are we finished? The answer is no.” It would be reasonable, based on established practice, to expect the ECB President to repeat this formulation in the coming months, until circumstances dictate a new message. But the utterances are increasingly reminiscent of the Wizard of Oz: “make no mistake, I have powers, powers beyond your understanding! Powers to make you quake!”
It is unlikely that the policies in place will result in an immediate return to the required levels of growth. Inflation is likely to remain low. The ECB believes that inflation will rise from current rates (0.5%) to 1.4% in 2016, despite downward revisions of its inflation forecast for the next three years. The pace of structural reforms in individual nations will remain slow, particularly in the face of electoral disquiet and with low borrowing costs reducing pressures for change. Already elevated debt levels will continue to increase, becoming unsustainable.
In the 5 June 2014 press conference, the ECB President acknowledged that almost all of policy makers’ conventional tools were now exhausted. With politicians having all but totally abnegated economic responsibility to monetary authorities, the ECB has only one more card left to play – a large-scale programme of asset purchases.
Leaving aside the Bundesbank’s resistance, legal and technical difficulties in implementing such a program, it is not clear that monetary expansion will be effective in stimulating aggregate demand. The ECB’s own simulations, reported by the Frankfurter Allgemeine, show that the impact of full scale quantitative easing (“QE”) on growth and inflation will be limited. The simulations indicated that a QE program of €1 trillion per year, roughly €80 billion per month, would increase inflation by only 0.2% to 0.8%.
Since July 2012, European policy makers and investors have ignored real economy weaknesses, choosing to concentrate on the effect of massive central bank liquidity injections. The strategy has generated spectacular returns. But the balance of risk and return is shifting.
Should growth and inflation not increase significantly and the present policies prove ineffective, Mr. Draghi’s bluff is likely to be called. The ECB President is relying on Mark Twain’s observation that: “It is sound judgment to put on a bold face and play your hand for a hundred times what it is worth; forty-nine times out of fifty nobody dares to call it, and you roll in the chips.” But as Ambrose Bierce knew: “The hardest tumble a man can take is to fall over his own bluff.”
© 2014 Satyajit Das
Satyajit Das is a former banker and author of Extreme Money and Traders Guns & Money