31 March 2016

On the 11th March Mario Draghi delved deep into his tool kit and pulled out a ‘big bazooka’ in a bid to end the Eurozone’s flirt with deflation. The stimulus package he unveiled included:

  1. Increasing in size of the QE program by €20bn to €80bn a month
  2. Expanding the class of eligible assets under QE to include investment grade, euro denominated, none financial corporate bonds
  3. Cutting its main interest rate from 0.05% to 0%
  4. Cutting its deposit rate from -0.3% to -0.4%
  5. Announcing a new series of Targeted Long Term Refinancing Operations (TLTRO’s) for financial institutions where they will be able to borrow from the ECB at rates of between 0% and -0.4%

Yet even with this latest stimulus package, the ECB only expects inflation to reach 1.6% by 2018; meaning inflation will have been below the ECB’s target of ‘close to but below 2%’ for five years. However even this projection may be optimistic as the latest package may not be as effective as expected.

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Increase in the size of QE

Probably the single largest component of the latest stimulus package was the increase in the size of QE by €20bn to €80bn a month. The ECB hopes that this will further driven down interest rates across a range of assets and further depreciate the euro thus spurring investment and exports helping to bring inflation back to target. However, as Open Europe has previously noted , the nature of the Euro-zone economy means that QE is unlikely to be as effective compared with the USA or UK. Furthermore, yields have already been pushed very low across many assets classes meaning this latest expansion of QE will likely suffer diminishing marginal returns. Moreover the ECB may not even be able to continue with QE in its current form as it is rapidly running out of assets to buy. Though the overall sovereign debt market is huge, rules over what bonds the ECB can purchase severely limits the quantity of assets it can buy. The ECB has limited itself to buying a maximum 33% share of any individual countries sovereign bonds and cannot buy bonds yielding less than its deposit rate. Analysts at ABN Amro have calculated that the ECB will breach the 33% limit for German, Finish and Portuguese bonds by March 2017, well before the program is meant to end. To make matters worse, this figure was calculated assuming an increase in QE to only €70bn a month. As the actual increase was larger, the ECB will run out of bonds even sooner than they estimate. Though there are ways the ECB could increase its pool of potential assets, these involve significant political, legal and economics costs (see next blog).

Expansion of QE to include corporate bonds

The expansion of eligible assets under QE to include investment grade, euro-denominated bonds issued by non-bank corporations established in the euro area could theoretically help overcome one of the main limitations of convention QE programs, namely that it depends on Banks actually passing on cheaper financing to firms. By cutting out the middle man, and directly improving the financing conditions of firms by buying their debt, the ECB hopes to spark an increase in investment and end Europe’s flirt with deflation.

However, as analysts from Deutsche Bank have pointed out, there is a major flaw in this policy: namely the lack of eligible corporate debt in the Euro-zones periphery. Of the estimated €418 billion of eligible corporate debt, the overwhelming majority (over 60%) is held by French and German firms with only a fractional being held in periphery countries. Therefore the policy will have the perverse effect of providing minimal, or even no, stimulus where it is needed most.

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Even aside from the geographical problem, there are two big questions with regards to impact of the corporate bond purchases – will it increase corporate bond issuance and, if it does, will this money be used for actual investment. On the first question there are initial signs that companies are responding with last week breaking the record level for corporate bond issuance in a single week. However, it is very early days and we need to wait and see if this is genuinely new issuance or firms simply bring forward planned issuance. If the flow of corporate bonds does not increase we could see further liquidity problems in what is ultimately quite a small market; which could worsen the shortage of safe assets in the Eurozone. On the second question, despite many companies already having sufficient cash to investment, many have not done so with them instead simply using it for buybacks or to aid corporate deleveraging. This does not bode well for the prospects of future bond issuance translating into higher investment in the real economy.

Cutting main interest rate 0%

It is important to note that cuts in the nominal interest rate doesn’t necessarily mean that the real cost of borrowing in the Eurozone is falling. As inflation has fallen faster than the ECB has cut nominal rates, real interest rates have risen substantially over the past four years. Falling inflation therefore blunts any potential stimulus from lower nominal rates.

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Cutting deposit rate to -0.4%

The logic behind cutting rates deeper into negative territory is exactly the same as the usual reason for cutting rates; at least in theory. Lower rates are meant to discourage banks from getting stuck with deposits at the ECB thereby encouraging them to lend them on and increasing the velocity of money. Furthermore, banks should pass on these lower rates to consumers which discourages savings and should spur increased spending. However the theory doesn’t seem to hold when rates go negative as banks have been unwilling to pass on negative rates to consumers. Faced with an effective tax on their deposits at the ECB and the unwillingness (or inability) to pass on the costs to consumers, many banks have loudly complained that the policy is harming their profitability and actually reducing their ability to lend to the real economy. Though there is limited evidence at the moment to support this assertion, the fact that almost 50% of Eurozone banks’ profits come from interest income mean this concern should not be treated lightly.

Furthermore, this problem is actually being compounded by QE. As the graph shows, QE dramatically increases the amount of excess reserves held at the ECB. By charging a negative rate on these reserves, the ECB is effectively taxing the Banks for excess deposits that the ECB has itself created. Therefore the current form of negative interest rates may be incompatible with the QE program.

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The launch of another round of Targeted Long Term Refinancing Operations (TLTRO’s) was perhaps the most surprising of the measures outlined by the ECB.  Under the program the ECB will essentially offer banks free money, by charging 0% on the loans, and could end up actually paying Banks to borrow as it is prepared to lower the interest rate offered to its deposit rate of -0.4%; depending on how much of the money the banks then loan out.

The reason this is surprising is because there appears to be very little demand for such as scheme from Banks themselves and it proved little success in the previous rounds. The ECB’s own latest survey of Banks has shown that the take up rate for previous TLTRO’s has declined substantially with only 21% of banks participating in the latest round. Participation in future rounds is likely to be even lower as only 10% of banks surveyed said they would definitely participate in future TLTRO’s. Such a low take up rate will severely limit the effectiveness of this policy.

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The most likely reason why the ECB launched this program despite there being little appetite for it is that the ECB is hoping this will ease fears over bank profitability due to the negative deposit rate by providing a scheme where banks can effectively offset the losses from the negative deposit rate by being paid by the ECB to borrow money. However if banks just end up using the scheme to improve their bottom line, it is unlikely that the money will end up where it really needs to go- lending to firms in the Eurozone periphery.

A lot of bark, not quite as much bite

In conclusion, given the state of the Eurozone data it seems the ECB had little choice but to act but it is hard to see these policies as a game changer. They face significant constraints and in some cases, such as the negative deposit rate and expanded QE, their interaction could prove counter productive. However, this does not mean that the ECB is completely out of ammunition (at least in theory). There are still plenty of other options the ECB could try but, as we will discuss in our next post, none of them are a panacea and there are usually good reasons why they have not been tried yet.