The suite of credit-easing policies the European Central Bank unveiled last week to try to stimulate the stalling European economies will have to offset another of the ECB’s policies if they are to have the desired impact.
Last week the ECB, forced to act by slowing growth and an inflation rate that is sliding towards deflation, lowered its key refinancing rate -- the rate at which banks can borrow from it -- to 0.15 per cent and announced a €400 billion targeted long-term lending package. It also cut the rate it pays on funds banks deposit with it to negative 10 basis points.
The strategy behind both the negative rate on deposits and the cheaper funding is obvious. It wants to encourage/coerce the banks into withdrawing the funds on deposit as part of the broader attempt to encourage them to lend more and stimulate economic activity.
The lower rates might also help to lower the value of the euro, making the eurozone economies more competitive and creating some inflationary pressures amid growing concern that Europe is heading towards the kind of generational economic winter that Japan has experienced since the early 1990s.
But will it work?
That depends on how the eurozone banks respond to the incentives and disincentives in the package -- and to the incentives and disincentives in the other leg of ECB policies.
As discussed previously (Stress is good for Europe's battered banks, 19 May) the eurozone’s banks are experiencing yet another round of stress-testing of their balance sheet quality and capital adequacy and this time it would appear the tests (unlike two earlier rounds) are credible.
The banks have been raising tens of billions of euros of new capital -- and shedding assets -- to improve their condition ahead of the November handover of their supervision from the European Banking Authority to the ECB. It is that imminent transfer of supervisory authority that appears to be behind the extra stringency with which the tests are being conducted.
The scramble by the banks to get their balance sheets in order, however, creates a question mark over the ECB’s attempt to push liquidity into the eurozone economies via the banking channel.
In order to improve their balance sheet ratios the banks aren’t just raising more capital but they are shedding assets and shrinking their lending in an environment that would inevitably see subdued demand for credit and economy-wide deleveraging anyway. It isn’t as though there isn’t access to liquidity already but rather that the banks haven’t been inclined to take advantage of it.
Even if they have access to more and cheaper funding from the ECB there may be a reluctance to grow their balance sheets, although the first tranche of the ECB package doesn’t become available until September.
In any event, with the stress tests and the gradual imposition of far tougher global banking regulations over the next few years one would expect banks generally and the eurozone banks in particular (because they collectively have done less than most other developed systems to strengthen their balance sheets since the 2008 crisis) to be cautious about lending growth.
The ECB does have another card it could play. It has signalled that it might introduce its own version of the quantitative easing, or asset-purchasing program (which the US is now trying to wean itself off) if last week’s measures don’t have the desired effect.
There’s a question mark over whether a eurozone QE program could be effective, given that its bond and securitised asset markets are far less developed and far shallower than those in the US.
There are also the continuing tensions inherent in the politics of the eurozone -- the Germans hated what was announced last week and would be even more violently opposed to a QE program.
The real problem confronting the European authorities is that, while borrowing costs for sovereigns and corporates have subsided from their crisis levels of only a couple of years ago and some progress has been made, at significant social cost, in reducing deficits the fundamental flaw in the eurozone’s structure -- a common currency overlaying quite disparate economies -- hasn’t been addressed.
Even if the ECB were successful in convincing banks to lend and in stimulating some modicum of growth, that would simply be papering over the inherent instability and the vulnerability to any fresh outbreak of crisis of the eurozone’s foundations.