Constantin Gurdgiev: «ECB will need further measures, including an outright QE»

ECB policy monetary decisions of last June 5 meeting were mixed – some positive, other very risky. At the end, it is in doubt if we will see a repair of the transmission channel, a trikle down for the real economy, or a remake of more bubble incentives for certain financial markets. Economist and blogger Constantin Gurdgiev alerts: «the stage is being set for a substantial bubble emerging in European equities valuations to parallel already established bubble in sovereign debt valuations.».

Gurdgiev is an economist born in Moscow, Russia, educated in the UCLA, University of Chicago, Johns Hopkins University, in the US, and Trinity College, Dublin, Ireland. He lectures in Finance in Trinity College, Dublin and in the UCD Michael Smurfit Graduate Business School, Ireland’s leading business school. He also serve as the Chairman of Ireland Russia Business Association, and hold non-executive appointment on the Investment Committee of Heinz Global Asset Management, LLC (US). He is editor of the blog TrueEconomics ( ).

Interview by Jorge Nascimento Rodrigues © June 2014
Portuguese version at Expresso online edition

What is your overall opinion of the ECB June announcements?

As was widely expected, at its June Governing Council meeting, the ECB made a bold move into the unchartered waters of ‘unorthodox’ monetary policies. Bound by already near-zero interest rates and complex web of previously announced measures (e.g. OMT, SMP, LTROs and ELAs), Frankfurt had little option, but to continue down the same path: greater complexity, more reliance on second order effects, more aggressive indirect provision of liquidity. While on the surface, objectives of the monetary policy innovations have changed (from liquidity supports in previous rounds of easing to addressing credit markets fragmentation, averting near-deflationary prices dynamics and lowering upward pressures on euro FX rates today), the ECB modus operandi remained largely unchanged. Thus, reductions in interest rates and the announcement of new TLTROs were broadly in-line with past measures, that have proven to be of limited effectiveness before and are likely to be of limited effectiveness also in the future.

«Two rather radical policies innovations»

And what is the role of the highly controversial negative rates and the sterilisation of SMP intervention in the sovereign bond market in 2010 and 2011?

Acknowledging the reality I mentioned — limited effectiveness –, Mario Draghi paired the direct measures with two rather radical policies innovations: the abandonment of sterilisation of the SMP and the negative deposit rates. The first one is aiming to support interest rates reductions with concrete increases in liquidity supply, alongside the TLTROs. The latter one is designed to create incentives for the banks to price down the risks in the interbank funding markets. Both are supposed to re-enforce each other to break the vicious cycle of fragmentation in the credit markets, whereby surplus liquidity created in the Northern European economies remains trapped in their banking systems without flowing to the Southern economies.

What is your expectation?

My expectation is that the ECB will need further measures, including an outright QE and broadly based ABS purchases to drive euro area credit supply and monetary aggregates to the levels where the economy can attain sufficient momentum to escape near-deflationary prices and support real economic recovery. These measures are likely to be introduced after the ECB review of banks balance sheets. However, June announcements are also likely to reduce the size of future QE measures, as introduction of TLROs and non-sterilisation of SMP will increase supply of liquidity in the corporate credit markets in the euro area. On the net, therefore, the ECB has boldly gone to deliver new firepower, while leaving the door open for more measures in the near future.

«Instead of much-anticipated start of an outright QE, the ECB opted for a scatter-gun approach of showering the credit markets with complex, seemingly disconnected policies.»

Did Draghi met the expectations of investors and analysts?

In part, June announcement re-affirmed Draghi’s commitment to sustain ECB’s activism in dealing with the threat of deflation. However, the policies stopped short of creating a coherent, strong and committed response. Instead of much-anticipated start of an outright QE, the ECB opted for a scatter-gun approach of showering the credit markets with complex, seemingly disconnected policies.

What was the immediate impact?

As the result, currency markets repriced euro to the upside [daily nominal effective exchange rate of the euro went up 0.3% in June 6] following the short-term correction in the immediate aftermath of the ECB statement [-0.4% in June 5], while bonds markets rallied strongly on expectation that June announcement will still have to be followed by an outright QE later this year.

Cutting the fixed rate to 0.15% will have a substantial impact where the 0.25% failed to “repair” the transmission channel?

Interest rate reductions alone will have no material impact on monetary dynamics or credit markets in the euro area. The reason for this is that the euro area credit system is severely fragmented across national boundaries and credit classes. In terms of national economies, surpluses of liquidity that are driving credit conditions down to their historically loose levels in the likes of Germany are contrasted by high cost of private sector credit in the Southern European economies. This problem is known to the ECB and remains in place irrespective of the lending rates policies. In credit classes terms, legacy debts in many weaker euro area economies are structured either on the basis of tracker loans (linked to the ECB headline rate), fixed rates or variable rates. When the lending rate declines on foot of ECB action, weaker banks (prevalent in the Southern Europe) face losses on tracker loans, which they offset by raising the cost of credit on variable rates.

What is the real impact?

The net effect on the economy is either neutral (in countries like Italy and Portugal, where vintages of legacy loans written before the onset of the crisis are relatively balanced across the loans types) or negative (in countries like Spain and Ireland, where higher levels of household and companies indebtedness is linked to shorter-term rate loans). In the latter case, lower ECB rates can, perversely, result in a greater stress on more indebted borrowers.

«Negative deposit rates work in both directions simultaneously, with net effect of the measure on macroeconomy and credit supply uncertain.»

The most controversial measure was the introduction of a negative rate on deposits. This decision will generate the desired effect of removing credit to the non-financial sector from continuous contraction?

Since, by themselves, lower lending rates can be a mixed blessing in the presence of markets fragmentation, the ECB has paired the latest cut with a negative deposit rate. This, in theory, can lower risk valuations of weaker banks and thus induce flow of credit from stronger banks to weaker banks, supporting new lending in the stressed economies. Alas, as common with economics, theory is not always consistent with the practice, nor does theory present an unambiguously positive picture of potential benefits from negative deposit rates. Negative rates, via increasing supply of liquidity into the economy, are hoped to drive up prices (reducing the impact of low inflation) and, simultaneously, lower euro valuations in the currency markets (thus stimulating euro area exports and making more expensive euro area imports). The good bit is obvious.

And the bad bit?

Energy costs, costs of related transport services, other necessities that euro area imports in large volumes will have to rise, reducing domestic demand and increasing production costs and lowering international competitiveness of European industries.

ECB unanimously chose a measure that even the Bank of Japan never adopted. Is this a high risk decision for Draghi & the Governing Council?

The US Fed Chair, Janet Yellen stated in November 2013 that deposits rates near zero (let alone in the negative territory) can trigger a significant disruption in the money markets. If banks withhold any funds from interbank markets, the new added cost of holding cash will have to be absorbed somewhere else. If the banks pass this cost onto customers by lowering deposit rates to households and companies, there can be re-allocation of deposits away from stronger banks (holding cash reserves) to weaker banks (offering higher deposit rates). This will reduce lending by better banks (less deposits) and will not do much for increasing lending proportionally by weaker banks (who will be paying higher cost of funding via deposits). Profit margins can also fall, leading all banks to raise lending costs for existent and new clients. If, however, the banks are not going to pass the cost of ECB deposits onto customers, then profit margins in the banks will shrink.

What will be the result?

The result, once again, can be reduced lending and higher credit costs and this outcome is more likely in the economies where banks are more protected and oligopolistic, such as in Southern Europe. One additional side effect of these negatives is that the new policy measure can amplify, not alleviate, markets fragmentation in the euro area.

Recently Denmark Central Bank just revoked negative rate on deposits…

When it comes to the international experience with negative rates, the record is spotted at best. Denmark relied on negative deposit rates between July 2012 and April 2014 to drive down the FX valuations of the Danish krona. This objective is distinct from the ECB’s objective of using negative rates to increase credit supply in the economy and reduce deflationary pressures. However, even as a support for currency valuations, the measure is yet to be proven effective. In Danish example, following the introduction of the negative rate, Krona depreciated via-a-vis Euro by about 1/2 of a percent from 7.43 to 7.46 – a level of change that can be attributed to many factors other than negative rates. More ominously, Danish experience shows that a deposit rate cut was not effective in increasing credit supply or in lowering interbank and market rates. It is worth noting that Denmark’s cut to the deposit rates came at the time of high and rising central bank deposits holdings, while the ECB negative rates are coming at the time when banks deposits with Frankfurt institution are well below their crisis period highs and are falling.

What lessons we can learn?

Earlier Swedish short experience with negative deposit rates [only through july to october 2010] confirms the lessons to be learned from the Danish experiment: negative deposit rates work in both directions simultaneously, with net effect of the measure on macroeconomy and credit supply uncertain.

«TLTRO cannot be used to purchase Government bonds – a major positive, given that funds from the previous LTROs primarily went to fund Government borrowing»

The decision to proceed with a new type of LTRO, now Targeted-LTRO, is a good option? Will TLTROs move banks to increase credit to the private non-financial sector?

By announcing a reduction in the lending rate and the negative deposit rate, the ECB has entered the unchartered territory where negative effects can counter positive ones with the net outcome of the key interest rates’ policies remaining uncertain. In response to this, the ECB boosted the liquidity supply available to all banks, while targeting this increase toward non-financial corporates and (to a lesser extent) consumers. To achieve this, the Central Bank announced a new round of LTROs – cheap funding for the banks – to the tune of EUR400 billion. The two new LTROs are with a twist.

With a twist?

Yes, they are ‘targeted’ to lending against banks loans to businesses and households, excluding mortgages. TLROs will have maturity of around 4 years (September 2018) and cannot be used to purchase Government bonds – a major positive, given that funds from the previous LTROs primarily went to fund Government borrowing. Banks will be entitled to borrow, initially, 7% of the total volume of their loans to non-financial corporations (NFCs) and households (excluding house loans) as of April 30, 2014 and subsequently, the ECB can expand this programme. The TLTROs will be issued in September and December 2014, when ECB will have a good visibility on assets quality in the euro area banking system. The fact that TLTROs will have several issuance dates – with initial allocations in September and December 2014 and, thereafter, on a quarterly basis from March 2015 to June 2016 – will give banks flexibility in converting funding into loans, and will provide ECB a number of future opportunities to expand the size of the programme, should demand for funding be robust enough. To further enhance liquidity cushion, the ECB declared that loan sales, securitisations and write downs will not be counted as a restriction on lending volumes under the TLTROs. TLTROs cost of funds is set at MRO rate, plus fixed spread of 10 bps, currently implying funding rate of 0.25bps. This is a major positive and induces certainty in terms of cost of funding new lending for the banks, but also setting TLTROs as an effective hedge against future increases in the Central Bank rates.

Is the conditionality for the TLTROs based on clear and transparent rules?

The TLTROs system is transparent and clear enough, with no restriction on asset quality that can be counted in the calculation of lending volumes. The model for the ECB move is Bank of England’s FLS (Funding for Lending) programme. So far, corporate assets held at the ECB have remained relatively fixed in volume terms from around 2009 through Q4 2013. TLTROs are likely to change this significantly, with a resulting improvement in funding available to some corporate lending markets, even in the credit-starved Southern European economies. On the balance, I believe that the TLTROs will help to alleviate credit supply constraints. However, it is not entirely clear as to whether there is sufficient demand in the debt-constrained economies of the euro ‘periphery’ for more lending.

«The core concern is that new measures will simply act to stimulate financial markets valuations and sovereign debt prices without trickling down into the real Economy.»

ECB has not opted for a quantitative easing. Will the ECB deploy a full QE in the near future?

In the short run, measures announced this June will help alleviate adverse dynamics in the euro area credit markets. But they are unlikely to result in a long-term improvement in the credit demand. This will require measures that can aid faster deleveraging across economies and sectors, such as outright purchases of debt, or QE, coupled with warehousing of purchased loans over long period of time and write downs and restructuring of some purchased assets. The former is likely to take place in the near future. The latter is not even on agenda, yet. With this in mind, we can look forward to the ECB continuing to develop ABS programme and make an announcement on it sometime in late Autumn 2014 – early 2015, depending on a number of catalysts, such as: uptake rate in TLTROs in September, asset quality reviews, and underlying growth and price dynamics in the euro area economy.

To sum up, the package will deliver for the real economy?

The core concern, following on the foot of the June meeting, is that new measures will simply act to stimulate financial markets valuations and sovereign debt prices without trickling down into the real economy – corporate capex [capital expenditire] and hiring. This concern is real. Since H2 2011, European Stoxx 600 index dynamics diverged from the underlying companies earnings per share (EPS) momentum as sustained gains in equities prices coincided with steady declines in EPS, as mentioned by Wolf Richter of, based on data from FactSet [see the chart in this link]. EPS of the 600 of Eurostoxx at 29 July 2011 was 26.27 euros; at 5 May 2014 lowered to 23.65 euros, based on data from FactSet. At this stage, it is hard to imagine how reduced cost of new lending (as opposed to legacy debt burdens) can support EPS momentum reversals. At the same time, we can expect improved funding costs in the banking sector to stimulate leverage and demand side for equities. The stage is being set for a substantial bubble emerging in European equities valuations to parallel already established bubble in sovereign debt valuations.

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