The ECB's dilemma requires radical action

Last week's €7.5 billion capital raising by the eurozone's biggest bank, Spain's Santander, underscores the complexity of the policy issues confronting the European Central Bank as it tries to balance the need to strengthen the banking system it now oversees while also trying to avert the threat of deflation.

Santander has reportedly denied that its share issue was in response to any ECB directive. However, the market's conclusion is that the transfer of supervisory responsibility for eurozone banks from individual central banks to the ECB in November has set the scene for a new round of capital raisings by the banks.

While most of the eurozone banks passed the latest round of stress tests last year, which were conducted by the ECB in preparation for its new responsibilities, over the past month the ECB has been setting specific minimum capital ratio targets for individual banks.

There is an expectation that a number of the larger eurozone banks will also, like Santander, call on the markets for additional capital in response to the targets they are given.

Since the financial crisis the eurozone banks have been incrementally improving their balance sheets via capital raisings and by reducing their asset bases.

There are plenty of analysts who don't believe the banks have raised enough capital while the attempt to improve capital ratios by shrinking balance sheets isn't exactly helpful to the ECB in its other role as the eurozone's central bank.

Last year the ECB tried to encourage the banks to lend more and stimulate some growth in the flat-lining eurozone by cutting the rate at which it lends to them to 0.15 per cent, and also by reducing the rate it pays on funds they deposit with it to encourage them to put those funds to work. Only about half the €400 million it made available was taken up.

With the attempt to stimulate some growth via the banking channel having no meaningful impact -- whether because the banks are reluctant to lend or because their customers are reluctant to borrow -- and the banks still focused on improving their balance sheet ratios, the ECB is on the verge of launching even less conventional policies to try to avert the threat of eurozone deflation.

In December the eurozone experienced a negative inflation rate, so that threat is real. While the impact on inflation of the plunge in oil prices might be a passing phenomenon, it will flow through into even lower prices over the next few months. If businesses and individuals expect prices to fall there is a disincentive to invest and spend.

Given that the fundamentals in Europe (public debt levels, unemployment and recession) are significantly worse than when Japan entered its two decades-plus of deflation and economic winter, the ECB is under increasing pressure to "do whatever it takes" to avert the threat by stimulating investment and consumption.

At next week's meeting of the ECB's governing council the ECB President, Mario Draghi, is expected to propose the ECB launch its version of the quantitative easing program pursued by the US Federal Reserve Board through the post-crisis period. That US QE program of bond and mortgage-buying, which expanded the Fed's balance sheet by about $US3.5 trillion, finally ended last October.

There are divided views about the efficacy of QE in the eurozone. There are also divided views about how effective QE was in the US in promoting growth in the real economy, as opposed to the speculative risk-taking it definitely encouraged in financial asset markets.

Europe's capital and asset-backed securities markets are nowhere near as developed as those in the US. Its banking channels are relatively far more important in funding businesses than in the US, and therefore there is a question mark over whether a US-style QE program would have any impact.

The ECB could expand dramatically on the strategies it has adopted since 2008 and fund large-scale purchases of sovereign debt.

This week the European Court of Justice is expected to make a non-binding ruling on an earlier ECB bond-buying program, albeit one that wasn't drawn upon. An adverse ruling on the issue (referred to the ECJ by Germany's Constitutional Court) might complicate the nature of any QE program and would certainly encourage further German opposition to purchases of sovereign debt.

The speculation in Europe is that the ECB wants to restrict its bond-buying to investment grade sovereign debt, which would avoid the 'Greek issue'.

The radical-left Syriza party, which wants to abandon its austerity program and write-off a big slab of Greece's sovereign debt, is favoured to win the popular vote on January 25. With the current eurozone bail-out deal with Greece expiring next month, speculation about a forced 'Grexit' -- Greece's exit from the Eurozone -- has re-emerged.

While a European version of QE might help some of the more heavily indebted governments of southern Europe, the greater importance of the banking channel means it isn't certain that even a quite large QE program would actually impact levels of economic activity in the eurozone unless the region were prepared to turn its back on austerity programs and channel the ECB's funding into deficits-expanding government spending.

More than six years after the financial crisis erupted the eurozone is still challenged by its aftermath, slipping back into recession and incipient deflation.

Whether that's because (unlike the US and UK) it didn't force its banks to recapitalise and restructure quickly enough and significantly enough or whether it is because countries like Italy and France also eschewed structural changes, the bottom line is that time hasn't papered over the structural flaws in the eurozone's economic and banking systems and, indeed, the structure of the European Union itself.

Mario Draghi's pledge to do "whatever it takes" in 2012 was remarkably effective in averting an earlier crisis despite the fact that the ECB didn't do anything much in the wake of that promise.

This time, if the ECB wants to try to help the eurozone avoid the kind of fate that has enveloped Japan since the early 1990s, it might actually have to do something substantial and radical.