14 March 2016

Paul Goldschmidt: The Prescriptions of the ECB - "Big Bazooka" or "Damp Squib"?

The spectacular increased volatility in several sectors of the financial markets (FX, equities, bonds) during and in the aftermath of President Draghi’s press conference on March 10th, during which he presented Urbi and Orbi the decisions of the ECB’s Governing Council, demonstrates the difficulties of undertaking such a communication exercise. [...]
 
The President was aiming to convey several messages: that the ECB was not giving up on its objective of stimulating the eurozone economy within the framework of its price stability mandate; that it was not short of ammunition to carry out its monetary policy and that, for the foreseeable future, unconventional monetary policies would supersede interest rate policies. He was thus confirming that his 2012 commitment to “do whatever it takes to support the euro” remained intact. [...]
 
Mario Draghi offered a very defensive argument as a justification for the Bank’s decisions: “If we had failed to act, we would have been accused of increasing the risks of deflation which would have been particularly penalising for debtors”. How then is it possible to reconcile simultaneously debt deleveraging and credit stimulation to support economic activity? Resolving this conundrum is particularly difficult within the Eurozone because budgetary and fiscal sovereignty, retained by Member States, makes targeting specific monetary policy measures, meant to be applied uniformly throughout the zone, far more complicated.
 
Let us now consider the expected impact of increasing by €20 billion, the monthly creation of additional liquidity. The beneficiaries should be in part the treasuries of EMU Member States. The positive impact on the economy will only be felt in the long term to the extent the proceeds are directed to productive investments (infrastructure, etc.) rather than to shoring up current budget deficits. Implementing further structural reforms is a necessary condition to give the bold ECB’s monetary policy any chance of succeeding. One can doubt that, over the short term, the expanded quantitative easing will lead to a positive impact from government spending other than through the illusion of temporary lower debt servicing costs.
 
As far as the purchase of corporate bonds is concerned, it should prove positive if it leads to increased borrowing for investment rather than to refinancing outstanding debt at lower cost or accelerating stock repurchase programs, the latter being at present the favoured route to boost earnings per share. The fact that credit demand is weak (due to the poor economic environment) rather than a shortage of the credit availability (due to the plethoric liquidity) does not bode well as far as the success of the proposed new measures.
 
The increase in quantitative easing should contribute to banking profits derived from their intermediation between issuers and the ECB. These operations carry little risk as long as the massive monthly purchases continue to provide a downward bias to interest rates as well as an opportunity to liquidate rapidly short term speculative positions but they do not contribute to fostering growth.
 
Nevertheless, it is probably the new offer of LTROs (long term refinancing operations) that offers the best chance of stimulating credit demand, in particular through the novel mechanism of interest rate subsidies which will improve the spreads earned on new loans to the real economy. Their success will remain subject to the capacity of each bank to adapt to the new prudential regulatory framework aiming at improving risk management. 
 
The ECB has mobilized an impressive arsenal of measures – “the big bazooka” – aimed at reversing prevailing pessimism and providing a boost to the timid recovery. This salvo could, however, amount to a mere “damp squib” if Member States failed to face up squarely their own responsibilities relying, once again, exclusively on the ECB’s monetary policy to carry the burden of unpopular measures needed to restore growth. [...]
 
In conclusion, Member States cannot just rely on hope, in the belief that a new crisis will necessarily offer the opportunity to relaunch successfully the European project.

Full article on Paul Goldschmidt website

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