BTMU Economic Brief | January 2015 1

BTMU Economic Brief

Eurozone: ECB to the Rescue AMIR KHAN ECONOMIC RESEARCH | LONDON T +44-(0)20-7577-2180 E Amir.Khan@uk.mufg.jp

The Bank of Tokyo-Mitsubishi UFJ, Ltd.

A member of MUFG, a global financial group ANUARY 2015 J

e have been predicting that the ECB would eventually resort to quantitative easing (QE) for some time now (see our Special Report, entitled: “The road to QE”, July 2014). But while QE was a long time in coming, the programme announced by Mario

Draghi, the ECB president, on 22 January, on balance, exceeded market expectations in terms of size and composition. But we remain sceptical that it will revive the Eurozone economy or, for that matter, inflation at least in the short-term.

W The ECB resorts to the “big bazooka”… With the Eurozone economy faced with near-stagnant growth and ongoing disinflationary pressures, such that the headline measures of inflation has now moved into negative territory (see Chart 1), the ECB has found that actual inflation has deviated further away from its 2% target (see Chart 2), thereby undermining its policy credibility and leaving it with no choice but to go down the road of full-blown QE. Indeed, having raised expectations to such an extent in the final stages of last year about its willingness to pursue QE, a decision not to have gone ahead at its meeting on 22 January would clearly have been taken badly by the investor community.

Chart 1: The ECB's headline measure of inflation has now moved into deflationary territory...

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Headline inflation (HICP) Core

Chart 2:…As prices continue to deviate further from its target, thereby undermining its credibility

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(%, y/y) (Deviation from the ECB's 2% target)

Source: Macrobond, BTMU

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Motivations for QE aside, what should we make of the details of the programme? In terms of size, the ECB QE programme is at the top end of market expectations. The ECB will buy €60bn of assets per month from March until September 2016, pointing to total purchases of about €1.1tn. This is close to the amount suggested by recent reports, but double the figure expected previously and enough to achieve the ECB’s stated aim of re-expanding its balance sheet back to early 2012 levels. Additionally, it is worth pointing that at around 10% of GDP, the ECB programme is close in size to the initial bouts of QE undertaken by US Fed and the Bank of England (see Chart 3). But the ECB has held open the prospect of an extension beyond next September by pledging to continue its purchases “until we see a sustained adjustment in the path of inflation”. While we view the open-ended nature of its commitment as a clear positive in terms of helping to shape market expectations, a cursory look at Chart 3 would appear to suggest that it would need to eventually at least double the programme to keep up with the Fed and the BoE, a prospect which in our view is likely to further add to the current discord between the German authorities and the direction being taken by the ECB.

Chart 3: Total stock of QE purchases by the major central banks

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Fed BoE ECB

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Source: ECB, BTMU

…But the programme is not without its limitations The ECB has, in the face of the recent rise in political tensions in Greece, neatly dealt with the thorny issue of how to exclude the country from the QE programme by limiting its holding of any single government’s outstanding debt to 33%, which it already own in Greece’s case via purchases made under the Security Market Programme (SMP). That said, a debt redemption in July might allow new ECB purchases of Greek bonds still to take place. Additionally, in terms of the €60bn monthly purchases that the ECB has earmarked, it is important to highlight this figure includes the existing bond purchase programmes, consisting of ABS and covered bond purchases, which amount to something like €10bn per month. So, in essence, the additional bond purchases are €50bn per month, in line with recent reports.

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These purchases will, in turn, consist of of investment grade sovereign bonds and debt of “agencies and European institutions”. A final, and perhaps more important, point worthy of mention here is that most of the sovereign debt will not be subject “loss-sharing” (80%). In other words, the risk will remain with national central banks. Taking stock While the markets rallied and the euro fell, as expected, in the immediate aftermath of the ECB’s QE announcement, it is too soon to judge the progamme to be a success. Our own sense, however, is that it may prove to be somewhat more disappointing than the initial market reaction would appear to suggest. In essence, the programme is expected to work through a number of key channels, as outlined in Table 1 below.

Table 1: Key channels through which QE is likely to work

Channel Comments Impact

Improving confidence

Past experience from the US and UK suggests that QE helps to support household/corporate confidence, thereby increasing their willingness to spend. But given that the process of private sector balance sheet repair still has further to run, the impact from this channel may be capped somewhat.

Moderate

More credit to the private sector

In theory, the expansion in banks balance sheets should result in more credit being made available to the private sector, but past experience from countries, such as Japan, urges caution given that banks in that country chose to hoard the extra cash rather extending it to the "real economy".

Low/moderate

Weakening of the euro exchange rate

Improved price competitiveness of the external sector supports growth. Also, a falling currency may help to push prices higher thanks to the concept of so-called "imported inflation".

High

Lower yields

Lower yields support investment and private consumption if it results in lower cost of borrowing. However, yields are already at a low level, suggesting that there is a limit to how much further they will fall.

Low/moderate

Asset price growth

Previous bouts of QE undertaken by the other major central banks gave a major boost to assets prices and we expect this to also play out on this occasion, though some gains have already taken place in anticipation of this move.

Moderate/high

Stronger signalling QE signals strong commitment to support inflation and this may, in the process, increase inflation expectations Moderate

Source: BTMU

The main reason we habour doubts as to the potential effectiveness of the ECB’s QE programme is owing to the delayed timing of this move and given the fact that a number of Eurozone countries, particularly those in the periphery, have already fallen into deflationary territory. Indeed, the experience of the US Fed and the Bank of England teaches us that QE work best when undertaken preemptively and in large enough doses. Additionally, over and above this, there are three other reasons why, as alluded to in the table above, we feel that the ECB’s QE efforts are likely to disappoint:

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With Eurozone sovereign bond yields already having seen a sharp falls in the run-up to the QE announcement, there is a limit to how much they will fall further and, in the process, benefit the wider economy.

While full-blown QE will make banks more flush with cash, the fact remains that European

banks still remain in deleveraging mode – a situation which is not being helped by the increasing regulatory demands being placed on them – and as such their willingness to lend to the “real economy” is likely to remain impaired.

A final, but related, point worth noting here is that – unlike the situation in the US and UK –

Eurozone companies are highly dependent on the banks, as opposed to the capital markets for their financing. This, in turn, will cap the extent to which they will be able to benefit from QE relative to their counterparts in the US and the UK.

Notwithstanding the potential challenges associated with QE, the policy is not without its merits. Foremost here is the fact by reducing the value of the euro against the currencies of its major trading partners we anticipate the policy giving the region’s export sector a boost, though much will also depend on the price elasticity of different countries exports. Indeed, on the announcement of QE – the euro fell in excess of 3% over a two day time period - and we feel that if this trend continues over a sustained period this could potentially help to improve performance of the Eurozone economy at least at the margins. That said, it is worth bearing in mind that while QE may give the economy a short-term boost through the trade and confidence channels, the crucial point to note is that to improve the long-term competitiveness prospects of any given economy in the Eurozone will also entail the need to adopt painful structural reforms, something which needs to given renewed impetus going forward, particularly in countries such as France and Italy, where there has been a reluctance to embrace such reforms until recently. Concluding thoughts While QE took a long time in coming to the Eurozone – in large part because of the complex institutional make-up of the ECB and the fact that it continues to be constrained by the “laissez- faire” views of the German Bundesbank – the good news is that the ECB has not disappointed what were, after all, pretty demanding expectations. The most important result of all this should be to sustain and perhaps extend the recent fall in the euro, probably the most important channel through which QE will affect the economy. But at the risk of sounding rather alarmist, we caution that international experience of QE has been mixed and that there are reasons – not least weakness of the banking system and already low levels of bond yields – to think that it might be less effective in the Eurozone than elsewhere.

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