Editor's note: This article by Myles Bradshaw originally
The U.S. Federal Reserve (Fed), Bank of Japan (BoJ) and Bank of
England (BoE) have all been heavily engaged in asset purchases. The
European Central Bank (ECB), in comparison, looks like a shrinking
violet. As of 13 May 2013, the Fed's and BoJ's balance sheets have
grown year-to-date by 14% and 10% respectively; the ECB's balance
sheet actually fell by 14%.
How central banks use their balance sheet is also important: asset
purchases are 10% of the ECB's balance sheet, but 97% of the Fed's.
The ECB has provided funding support but, in contrast to the Fed,
has transferred much less risk from investors' balance sheets. The
result is that it has done less to help banks deleverage, improve
their capital ratios and hence increase their willingness to lend.
Investors should be wary of extrapolating this status quo -
Europe's weak economic outlook means that we should expect the ECB
to become more, not less, engaged. The response is likely to remain
fitful, switching from "Whatever It Takes" (
) to conditional support. We have already seen this with the ECB's
Outright Monetary Transaction (OMT) program which was conceived as
unlimited support to tackle "convertibility risk" but has been
diluted to a conditional program as sovereign spreads have
Macro Outlook Suggest the ECB Will Need to Act On the Basis
of "Price Stability"
The mid-point of the ECB's GDP forecast, -0.5% in 2013 and +1% in
2014, is in line with consensus. And this implies that the eurozone
will return to trend growth toward the end of 2014.
The macro data suggests that more needs to be done to boost
confidence to secure the forecast economic recovery. Figure 1 shows
that, despite improving financial conditions in the eurozone, Banca
D'Italia's EuroCoin estimate of GDP and the Markit Eurozone PMI
survey remain consistent with recession in Q2 2013.
The ECB's own assessment is that growth will strengthen as exports
grow and ECB monetary policy supports eurozone domestic demand. But
it is difficult to see how monetary policy can work when the
transmission mechanism remains broken. Figure 2, which shows the
divergence in the cost of credit for eurozone small companies,
reminds us that the eurozone policy response has still not fixed
the monetary transmission mechanism.
Without much needed growth, the risk that inflation under-shoots
the ECB's definition of its price stability mandate, "close to but
below 2% inflation", rises. The eurozone's annual Consumer Price
) fell from 1.7% to 1.2% in April 2013 (according to Eurostat).
While some of this may reflect the timing of Easter, it is also
worth noting that the ECB's own forecast is for low inflation: 2014
mid-point is 1.3%.
The macro data suggests that the ECB may now start to use its
balance sheet more proactively to target growth and inflation. With
that in mind, what might the ECB do next?
Further Rate Cuts are Highly Likely
European banks have been repaying ECB long-term refinancing
operation (LTRO) borrowings at a €6.5 billion weekly pace since
April 2013. At this rate, excess liquidity will be below €200
billion this October 2013 (see Figure 3), a level that in the past
coincided with overnight money market rates beginning to move away
from the ECB's 0% deposit rate and towards the ECB's 0.5% main
A further interest rate cut therefore seems likely as we believe
the economic outlook does not warrant an endogenous tightening in
ECB monetary policy. But this is not an incremental monetary
Fixing the Transmission Mechanism
Mr. Draghi has stated that the fragmented transmission mechanism
started with the sovereign debt crisis. He has asserted that some
of this fragmentation reflects issues beyond the ECB's control,
specifically the lack of bank capital. But this is a weak argument
for why the ECB should not address parts of the problem that reside
within its realm of influence.
First Best Solution: A Political Non-Starter
As recently as March 2013, Mr. Draghi asserted that credit is
expensive in Europe's periphery because local banks "…buy [high
yielding] government bonds, or lend to the private sector at a much
higher rate than the yields on government bonds." He went on to say
that normally, banks in other parts of the eurozone "…would take
the opportunity to either buy other countries' government bonds
themselves, so that the yields on those bonds would go down, and
the domestic banks would then have more incentives to lend to the
private sector… ."
The direct way for the ECB to address this problem would be to
intervene and lower the relevant government bond yields. Legal
arguments are probably overblown: European Union (
) treaties have not prevented the ECB from buying government bonds.
The key political constraint is that large scale ECB purchases
would represent a form of eurozone debt mutualization. Germany, as
the largest and most credit-worthy ECB shareholder, would likely
become more engaged in under-writing peripheral credit risk
elsewhere. This has implications for ECB political independence,
something the Fed does not have to worry about. It is also
something Germany is resistant to unless accompanied with greater
controls over the conduct of peripheral fiscal policy.
Second Best Solution: Lower Banks' Funding Costs to Reduce
the Cost of Credit
The ECB has initiated discussions with other European institutions
to promote a functioning asset-backed securities (ABS) market,
raising the prospect of ECB credit easing. While quantitative
easing (QE) seeks to encourage more risk-taking by lowering the
potential return from owning perceived "safe assets", credit easing
is an attempt to lower the cost and increase the provision of
However, unlike the U.S., European credit is intermediated by the
banking system and remains on banks' balance sheets. Without an
active securitization market, there are few "risky" instruments
that the ECB can buy.
Developing the ABS market will likely take some time. Gross public
ABS issuance is running at €20 billion in 2013, down from €325
billion in 2007. Even in the "good old days", ABS was only common
in some national markets: Spain, Netherlands and UK accounted for
53% of 2007 publicly distributed ABS issuance (Source: J. P.
Morgan, 13 May 2013). Creating a harmonized set of ABS regulations
and transparent data for different national markets will involve
difficult negotiations with a variety of national and regional
We should not expect rapid progress and should not be surprised if
the ECB changes tack and buys other private assets, such as banks'
loans, or allows national central banks to create national schemes.
Even making it easier for banks to repo a wider variety of ABS at a
lower hair-cut should help by reducing peripheral banks' dependence
on more expensive senior unsecured bond market funding.
Details Matter, But a Well-Designed Asset Purchase Program
Could Help Banks Deleverage
To have a meaningful impact on the broken transmission mechanism,
any ECB program needs to lower the cost of credit in the most
affected economies: peripheral Europe. This could potentially be
achieved by creating a program that is regionally tailored or big
enough if assets are purchased on a prorate basis.
Purchasing private assets could directly lower the cost of credit
for borrowers in peripheral economies and have significant positive
indirect effects. Banks could either use the proceeds from asset
sales to buy other high yielding assets, such as peripheral
government bonds, or reduce their reliance on wholesale financing,
i.e., reduce the supply of high yielding senior bank bonds.
More importantly, purchasing private assets could help the European
banking system to further deleverage. To do this, the ECB, or some
other European institution, must go beyond simply providing funding
support that occurs when banks repo bonds at the ECB or sell
super-senior ABS tranches. Instead they must engage in some form of
risk transfer. For example, if banks sold whole loans or the
subordinated part of the ABS capital structure, they could reduce
their risk-weighted assets and hence raise capital ratios. This
could be the most powerful way to increase banks' willingness and
ability to lend.
Negative Interest Rates: A Less Effective Form of QE With
Mr. Draghi has raised the possibility of cutting the ECB's 0%
deposit rate. Such action would probably push short-dated market
rates into negative territory, effectively charging global
investors for holding euros. Consequently, we'd expect a weaker
euro, which would be stimulatory for the entire eurozone.
Negative ECB deposit rates could at the margin make peripheral
assets relatively more attractive to investors. But it would be a
surprise if a 0.25% penalty were enough to fix the transmission
mechanism. A broken transmission mechanism implies that investors
have become unresponsive to small changes in relative prices. This
suggests policymakers need to do more than simply tweak relative
Negative interest rates could also have significant unintended
consequences. The negative impact on the eurozone's money market,
pension, insurance and repo industries are difficult to quantify
but could be potentially significant. Core country banks' net
interest margins would also be depressed by negative interest
rates, although we believe a negative 25 basis points penalty would
probably be manageable.
Super-Long LTROs Not a Game Changer
Given the technical difficulties of an ABS purchase program and
uncertain consequences of negative interest rates, the ECB may opt
for doing more of the same. A super-long, for example 5-year, repo
operation, or regular 3-year LTROs, would be technically much
easier to implement than asset purchases.
A more regular provision of multi-year ECB liquidity might
encourage some banks to increase their leverage and seek to earn
more carry from buying longer-dated and risky assets. But it would
likely be difficult to sustain this given the deleveraging demands
of both markets and regulators.
The recent fall in risk spreads suggest that the market's
perception of liquidity risks is currently relatively low. So it's
not clear that risk premiums would fall much if the ECB sought to
lower liquidity risks further by implementing a regular multi-year
ECB repo operation.
The technical difficulties in creating an asset purchase program
and the consequences of cutting deposit rates into negative
territory suggest that designing new non-standard measures will
take some time. But without a pick-up in business confidence, the
likelihood of more ECB action will increase.
In our opinion, the ECB will be most effective if it can design a
program that helps banks deleverage more quickly rather than simply
providing cheaper funding. Unfortunately, the political obstacles
suggest that the ECB's response will probably continue to be "too
slow or not quite enough" to tackle the low growth outlook.
More unconventional ECB measures may help maintain the wedge that
has developed between the valuation on risky assets and the
economic growth prospects. But we believe long-term investors
should remain focused on the quality of issuers' balance sheets
rather than simply taking more risk because of lower prospective