Eurozone: Killing two birds with one stone

  • Two of the major issues encompassing EZ are strong Euro and deflationary forces. While the former could hurt exports, the primary source of GDP growth; the latter has an adverse effect on domestic demand.
  • Our analysis reveals that banks behaviour has further aggravated these adverse forces in EZ. Thus, monetary easing in EZ must be targeted to incentivize banks to increase private sector lending. This could be achieved by announcing creditlinked LTRO1.
  • This measure could reverse the shrinking balance sheet and, thus, result in weaker Euro. Additionally, it could also push domestic demand higher and fight deflationary forces.

European banks’ behaviour aggravated deflationary forces…

 

In March 2014, the size of the balance sheet of European banks was 12.2% lower than its all-time peak less than two years ago. In absolute terms, total assets were at the lowest level (barring December 2013) since March 2008.The primary cause of this de-leveraging has been banks’ reluctance to give credit to the private sector (or real economy), which has increased (in MoM terms) in only four months since December 2011 and stood 6.6% lower than its all-time peak in October 2011. Without credit, domestic demand remains subdued, which is having an adverse impact on the inflationary forces.

 

However, EZ banks have increased their exposure to sovereign bonds, especially after Longer-term refinance operations (LTROs) were conducted. Credit to government in March 2014 was 13% higher than what it was in October 2011. As % of total assets, banks’ exposure increased from ~7% in pre-crisis period to 9.4% in March.

 

…and contributed to stronger Euro also

 

While banks are reluctant to lend, they have been (p)repaying their balance due to ECB on account of twin LTROs. Since the beginning of 2013, banks have prepaid ~EUR 534 bn (~53% of total borrowings), which has led to a sharp contraction in ECB’s balance sheet, which is equivalent to monetary tightening. This is in sharp contrast to the still expanding central bank’s balance sheet in the US and Japan, which has contributed to stronger Euro.

 

Killing two birds with one stone

We have been advocating for further monetary easing by ECB for the past six months now2. Nevertheless, it must be carefully designed so that it addresses the pertinent issues. We believe that a credit-linked LTRO, accompanied by extending the maturity of previous LTROs, could be helpful to break this deleveraging behaviour of banks. This can be achieved by incentivizing banks to increase credit to the real sector (in line with UK’s funding for lending scheme, FLS). Unlike previous LTROs, ECB could provide only a very moderate sum of money upfront to banks, which are not de-leveraging extensively (say, <5%), at even cheaper rate. Going forward, banks could claim further cheaper capital from ECB in return of their actual private credit in that period. With lower cost, banks would like to pass-on the benefits to customers, who will be tempted to borrow more. This might push domestic demand, helping fight deflationary forces. Additionally, this could reverse the contraction in banks’balance sheet, and help the Euro to weaken.

  1. http://treasury-research.icicibank.com/UploadFiles/Euro_Outlook_2014.pdf
  2. http://treasury-research.icicibank.com/UploadFiles/ECB Balance Sheet November 2013.pdf

 

 

EZ banks have de-leveraged owing to subdued private credit

 

The size of EZ banking sector declined 0.5% MoM again in March 2014, as aaginst a growth of 1.5% MoM in January, which was the first growth in nine months. The primary cause of the shrinking balance sheet is banks’ reluctance to give credit to the private sector (synonymous to non-government non-financialsector). Notably, the trend is not limited to periphery region.

 

As chart 2 shows, the size of German banking sector has reduced by 10% since October 2011, as against 8.2% for the entire region. The worst de-leveraging has taken place in Cyprus (-33%), followed by Ireland (-28%).

Notably, even though the size of Italian banking sector is higher than in pre-LTRO period, credit to private sector was ~5% lower than in October 2011. The growth in Italian banks has come due to higher government credit, which will be discussed in the next section. In fact, the free fall in private credit in Spain (chart 3) is the second worst (followed closely by Portugal) among 17 euro nations, following Slovenia. On the other hand, private credit post-LTROs has increased in Belgium (1%), Estonia (3%), Greece (1%), Slovakia (11%) and Finland (14%).

 

This sharp de-leveraging has contributed to disinflationary forces in EZ, as lowercredit reflects lower domestic demand.

Government credit, however, continues to increase

 

In contrast, banks have increased their exposure to the government sector. In fact, in countries like Italy and Spain, banks investment in sovereign bonds jumped immediately after LTROs, which indicate that most of the money was parked in the government sector, at the cost of private sector.

 

Chart 4 shows that except in Germany, bank credit to general government has risen sharply post LTROs. Italian and Spanish banks have increased their exposure to the government sector by the most among major euro nations.

It is important to note that while private credit has declined 5% in Italy since October 2011, banks’ investment in government securities has increased by almost two-third, marking the second highest growth in any euro member. Spanish banking sector leads, as they increased their holding of sovereign bonds by ~70%. As chart 5 shows, monetary financial institutions (MFIs) have increased their exposure to sovereign bonds since LTRO-I in almost all major euro members. MFIs have increased their investment in government bonds by 27% for the entire EZ, as against a decline of 8% in the previous two years.

 

This rising exposure of banking sector to government bonds poses a serious risk to the stability of EZ. By the end of January 2015, EZ banks need to repay another ~EUR 480 bn on account of twin LTROs. In case, banks need to sell their bond holdings to raise the funds, bonds market will come under severe pressure, creating a vicious circle.

Banks behaviour has also contributed to stronger Euro

 

Another direct impact of EZ banks’ de-leveraging is its contractionary effect on ECB’s balance sheet. Almost three-fifth of the fall in ECB’s balance sheet has materialized due to de-leveraging by EZ commercial banks. Not surprisingly then, money supply (M3) growth is hovering around 1.0% YoY, as against an average of 3% in 2012.

 

In case, LTRO repayments maintain status quo, ECB balance sheet could fall at least by another 10% by January 2015, pushing the currency even higher, adversely impacting region’s competitiveness. Not to mention, this could turn current disinflation into actual deflation.

EZ commercial banks have repaid more than half of EUR 1 trillion borrowed under the twin LTROs conducted in late 2011 and early 2012. While the development, in isolation, gives an impression of improving health of banks, declining private credit raises questions. This is one of the primary reasons,we believe, why, notwithstanding persistent fall in excess liquidity (down from EUR 600 bn in early 2013 to less than EUR 100 bn now), short-term rate (EONIA) has not tightened drastically.

 

Thus, if banks stop de-leveraging and demand capital to increase private credit, it might tighten EONIA rates. Therefore, any measure, which is targeted to change banks behaviour, must take this factor into consideration and take counter measures to fight these adverse impacts.

Killing two birds with one stone

 

So what can be done? As we have stated earlier also, European Central Bank (ECB) needs to take an even bigger role. In its recent monetary policy meet, Mr. Draghi stated that quantitative easing (QE) was discussed in the pre-policy meet. This has raised the prospects of another QE. Nevertheless, it is important to design QE in such a manner so that it addresses the two pertinent issues—low inflation and strong Euro—in EZ.

 

As we have discussed above, one common factor that has aggravated both these issues is EZ banks’ behaviour. While sharp de-leveraging has added to deflationary forces, banks’ repayment of LTROs has led to contraction in ECB’s balance sheet, which is one of the major factors leading to strong Euro. Therefore, ECB must design its QE in a manner that incentivizes banks to stop de-leveraging. Furthermore, it must reverse the monetary tightening in theform of contracting central banks’ balance sheet. We believe that it can achieve both these objectives by announcing a credit-linked LTRO, which can be accompanied by extending the maturity of previous LTROs.

Extension of maturity, say, from three to five years, of previous LTROs will not only send a strong signal to the markets, but will ease the pressure on ECB’s balance sheet, which has contracted ~30% since the beginning of 2013.While few banks may still choose to prepay, some banks would definitely like to use these cheap funds to lend into the retail market.

 

The targeted LTRO-III, on the other hand, could replicate some of the features of funding for lending schemes (FLS) in the UK, wherein banks, which are notde-leveraging severely, are eligible to receive a fixed moderate amount of extremely cheap financing upfront. Going forward, banks could claim further cheaper capital from ECB in return of their actual private credit in that period. With lower cost, banks would like to pass-on the benefits to customers, who will be tempted to borrow more. This might push domestic demand, helping fight deflationary forces. Additionally, this could reverse the contraction in banks’ balance sheet, and help the Euro to weaken.

As far as negative impact on EONIA is concerned, it will be taken care by providing further liquidity to banks by announcing LTRO-III. Moreover, extension of previous LTROs will also help restrict the dwindling excess liquidity.

 

Overall, these measures could help weaken the common currency by reversing the contraction in ECB’s balance sheet. Furthermore, by incentivising banks to increase private sector credit, domestic demand will get a boost adding to inflationary forces. At the same time, it could help push economic recovery and reduce the inter-linkages between banks and sovereign bonds market.