Mario Draghi’s modern dream of Sisyphus

Mario Draghi could feel a bit like Sisyphus these days. Not in the sense that he might think that it takes a lot of repeated efforts to success but – perhaps in a more existentialistic interpretation – in the sense that whatever the measure he takes, it will never succeed to curb on inflation, but he has to try further and further…

The radical change in the ECB President’s tone during the press conference on 8 May has raised many hopes with regard to the ECB’s response to the context of persistently tame inflation. Most of these hopes are likely to be dashed:

1- The low level of inflation and how the ECB can respond to this situation

In the euro zone, the low level of inflation is due to:

  • The weakness of commodity prices;
  • The reduction in the tax wedge as a result of the reforms undertaken in the periphery (liberalisation of goods prices and change in wage rules);
  • The exchange rate, which is tightening monetary conditions;
  • The weakness of domestic demand, for which the problem remains corporate investment.

For the sake of symmetry with its inflation target, it cannot be denied that the ECB should combat this low inflation. But it cannot do anything as regards the first two reasons cited above. Its priorities are therefore to weaken the exchange rate and to stimulate corporate investment.

2- Priority 1: Weaken the exchange rate

There are a number of determinants of the exchange rate, and they change over time. Currently, the euro zone’s current-account surpluses with the rest of the world explain the strength of the euro. The ECB cannot do anything about this situation. The interest rates gap with world rates is another determinant of the exchange rate, on which the ECB can act, but it has hardly any effect currently.

The euro’s exchange rate has fallen noticeably after Mario Draghi’s announcement that there might be a rate cut on June 5th and the confirmation of these expectations by other Council members since then. But will a decision to cut key intervention rates by 10 to 15 bp on June 5th weaken the common currency even more? That cannot be taken for granted. It is not obvious that the changeover to a slightly negative deposit rate on all excess reserves would encourage European banks’ treasurers to systematically swap their liquidity into FX currencies that provide positive interest rates: such an operation has a cost, which may increase if it is combined with a hedge against the currency risk.

Moreover, the effect of a rate cut on the exchange rate depends on the existing level of liquidity (around EUR 115 bn currently). In theory, the higher it is, the greater the effect on the exchange rate. But combining a new LTRO with a rate cut on June 5th could send an ambiguous message to banks, since this new liquidity would be taxed by negative interest rates if unused. On the other hand, negative interest rates would speed up the repayment of the VLTROs. One solution would be to stop the sterilisation of the SMP programme. However, this would come up against political hostility from the Northern countries - even though the Bundesbank apparently is no longer opposed to this solution - as it would erase the line separating the SMP from direct financing of Member States.

Can the ECB intervene directly in the markets to change the direction of the exchange rate? No, first because it has repeatedly stated that it does not consider the exchange rate to be a monetary policy objective per se; and also because it has to comply with its international commitments. We should bear in mind that Japanese Prime Minister Abe had been roundly criticised by the G7 for the use of the yen for reflationary purposes in Japan.

Can the ECB weaken the euro through unconventional monetary policy? Again, no. The announcement of a large-scale asset purchase programme - as some have recommended - could on the contrary lead to an appreciation of the currency, by initially encouraging foreign investors to buy assets denominated in euros. That happened in Great Britain when the BoE bought Gilts.

A large-scale QE would also have the drawback of pushing the core euro-zone interest rates down to an absurd level while wiping out the risk premium on the periphery. If the ECB accepted these two drawbacks, which is very unlikely, then the euro would actually fall by attracting less capital from non-residents into the bond markets. But this mechanism would work only in a second phase.

3- Priority 2: Stimulate corporate investment

Beyond the lack of confidence among economic agents and the deflationary equilibrium, the following factors are currently hampering corporate investment in the euro zone:

  • The absence of convergence between member countries‘ interest rates on business loans
  • In parallel, the lack of production of new loans to SMEs in the periphery.

Until now, no instrument introduced by the ECB has targeted these problems. The banks, especially Italian and Spanish, have massively securitised loans to SMEs to take advantage of ECB funding, but this has not had any positive impact on the production of new loans to SMEs, and the market remains thin. Moreover, while launching a purchase programme of ABS or CLO backed by loans to SMEs would contribute to a tightening of the spreads on these assets and probably would stimulate loan production, it would not improve the underlying quality of these loans. 

Accordingly, the ECB could introduce a programme of preferential funding of SMEs loans. The question that arises is what incentives the banks would have to subscribe to such a plan. In January 2014, the Bank of England changed its “Funding for Lending” facility and made it available exclusively for SMEs, enabling banks that grant a positive net amount of loans to SMEs to obtain an advantage in terms of liquidity cost. With refinancing rates at zero and taxation of excess liquidity, the ECB would have to provide free funding over a long period of time: 60% of business loans in the euro zone have a maturity in excess of 5 years.

The ECB could also buy supranational, EIB-type bonds to help finance investments. But this would also have an impact on the exchange rate via the non-resident purchase channel. Buying sovereign bonds directly would raise many problems for the ECB, chief among which the distribution of the purchases:

  • If the ECB complies with the national keys for the contributions to the Eurosystems’ capital, the Bundesbank would have to buy Bunds, which is at odds with the spirit in which the SMP was set up.
  • If the ECB buys government bonds on a pro rata basis of the outstanding amount of bonds, it would amount to favouring German and French bonds, and therefore the core.

Also, it seems difficult to launch such a programme as long as the ECB is carrying out the bank balance sheet review and the stress tests: it would simply invalidate the results of this review next autumn. Lastly, the probability of seeing an asset purchase programme being launched by the ECB is currently 21%, if we assume that inflation would be the trigger of such a programme and that the confidence interval on the ECB’s own inflation projections [0.5%;2.0%] is 58%.

The ECB could also consider guaranteeing interbank funding, so that peripheral banks could obtain cheaper funding. Nevertheless, little short-term funding is raised by banks to finance long-term loans. Also, as Basel III imposes a counterparty risk weighting on interbank funding, it is not a suitable instrument for giving a boost to the interbank market. It is not obvious that the ECB can bypass this problem.

4- Could the ECB come up with a surprise?

Beyond all these possible instruments, we should not rule out the possibility that the ECB could seek to come up with a surprise.

In that case, it could consider a purchase programme of assets that are not eligible for refinancing operations. This would first of all involve equities (withdrawn from the collateral pool in 2004). The Bank of Japan applied such a program with success in the past. Nevertheless, the lack of wealth effects in the euro zone and the need to target small business investment hardly point to such a solution.

Apart from these options, the ECB could consider using non-financial assets. This brings us to ideas like “helicopter money” in the form of a cheque with an expiry date, distributed to euro-zone companies to finance investments. This is very unlikely barring an Armageddon, even though Axel Weber made a proposal to this effect at the beginning of the financial crisis.

Über den Autor

  • Sylvain Broyer

    Sylvain Broyer

    Chief EMEA Economist, S&P Global Ratings.

    Sylvain joined S&P Global Ratings in September 2018 as Chief EMEA Economist, based in Frankfurt.
    Before that, Sylvain was Head of Economics at the French investment bank Natixis and a member of the General Management of its German Branch.
    Sylvain has been a member of the “ECB shadow Council”, a panel of leading European economists formed by German economic daily Handelsblatt since November 2012, and is a member of different public sector advisory groups.
    Sylvain holds doctorate degrees in Economics from the Universities of Frankfurt and of Lyon as well as a certification from the International Securities Market Association (ISMA). He teaches at the Paris Dauphine University for the Master in Banking & Finance.

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