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