Reviewing the borrowing costs of European nations, a visiting intelligent alien may conclude that the European economic crisis is over and rehabilitation complete.
Ten-year government bond rates for Spain, Portugal, Ireland and Greece have fallen sharply. They are comparable to that of the US, UK, Canada and Australia. A little over a year after requiring a bailout, Cyprus returned to bond markets in June 2014 with a euro 750 million five-year bond at 4.85 per cent, which was substantially over-subscribed.
But European rates do not reflect fundamental factors, merely the effect of massive liquidity injections from the European Central Bank (ECB).
The recovery from the recession is weak. The risk of a relapse is ever present. Growth, employment and investment are moribund. Disinflation or deflation risks are increasing, threatening to make a difficult debt problem unmanageable. The inadequacy of policy instruments is increasingly evident.
Responding to external pressure and its own oft-repeated willingness to act, on June 5, 2014, the ECB announced a series of measures designed to counter identified problems.
Official euro rates were, de facto, reduced to the lower bound of zero. A negative deposit rate was instituted for certain balances held with the ECB and euro-system.
The ECB ended sterilisation of the Securities Market Programme purchases, injecting around euro 160 billion into euro zone money markets.
The centrepiece was a new, complex funding-for-lending scheme - the targeted longer-term refinancing operation (TLTRO). The ECB will finance up to seven per cent of bank loans to non-financial corporations. Assuming around euro 5.7 trillion of eligible assets, the TLTRO equals new funding of approximately euro 400 billion. TLTRO loans will mature in September 2018. The loans will be at fixed rates of around 0.25 per cent.
In addition, the ECB proposed purchases of asset-backed securities (ABS) to increase funding for businesses, although details would be worked out in the future.
The initiatives are designed to counter "lowflation", increase supply of credit to create growth and weaken the euro to increase European exporters' competitiveness and counter disinflationary pressures from a strong currency.
European optimists believe that the ECB's "monetary policy fireworks" represent a decisive turning point. Pessimists point to previous false dawns and ineffective policies.
The interest rate cuts were largely a technical exercise, having little impact on market rates. The easing of interest rates implied by the ECB's initiatives is illusory. Using a Taylor rule approach, German interest rates, based on its domestic condition, should be around 4.65 per cent but would need to be around minus 10.75 per cent for Spain or minus 19.25 per cent for Greece.
The Danish experiment with negative interest rates suggests low efficacy, with limited change in monetary conditions. Negative rates act as a tax on banks, forcing them to lend rather than hoard cash. But with European banks' deposits and reserves with the ECB at low levels, the effectiveness of the measure is questionable.
The TLTRO assumes there is demand for loans. With the strong likelihood that the euro zone is in a Japanese-style balance sheet recession, credit demand may remain weak.
Banks may also not be willing to lend since they are still rebuilding capital and reducing balance sheets. This reflects the effects of the recession and new bank regulations. Banks' ability to provide credit may also be affected by the ECB's Asset Quality Review, which may require banks to write off debt and raise additional capital.
The previous two LTRO rounds saw ECB funding used primarily to finance governments. Estimates suggest that as little as five per cent went into the real economy. The TLTRO is designed to provide low-cost funding to businesses, especially small and medium sized enterprises to spur employment and investment. But given the fungible nature of money and the separation of banks assets and liabilities, the ECB will have limited control over the use of funds.
In practice, the TLTRO may marginally increase availability of credit in the euro zone. It is likely that the TLTRO will operate similarly to the earlier LTROs providing cheap funding for banks to buy government and corporate bonds. The low-risk profit will boost bank profits rather than economic activity. The sharp rise in bank share prices reflects the stock market belief that this is the likely outcome.
Increased bank holding of government bonds also increases the dangerous feedback relationship between sovereigns and financial institutions, referred to as the "doom loop". European bank holdings of sovereign bonds, primarily domestic government bonds, have reached 5.8 per cent of total assets, a significant increase from 4.3 per cent in January 2012. Italian banks hold 10.2 per cent of their assets in government debt (up from 6.8 per cent in January 2012). Spanish banks hold 9.5 per cent of assets in government bonds (up from 6.3 per cent in January 2012).
ECB purchases of ABS are unlikely to be effective in the near term because outstanding volumes are modest. Total issuance of European securitised assets were euro 251 billion in 2012 versus euro 1.55 trillion in the US. With a portion of outstanding ABS already committed as collateral in ECB repos, the available volume is limited. The ABS market is also small compared to the euro 17 trillion in outstanding bank loans.
This means that the ECB will need to incentivise banks to create them in the first place. But there are significant technical hurdles to creating a sizeable European ABS market in the near term. The ECB's encouragement of ABS issuance will face opposition from European banking regulators who are in the process of tightening regulations, including increasing the amount of capital to be held against these securities.
While the policy measures will continue to support bond, stocks and property prices, they are unlikely to restore growth or economic activity.
The writer is a former banker and author of Extreme Money and Traders, Guns & Money
Disclaimer: These are personal views of the writer. They do not necessarily reflect the opinion of www.business-standard.com or the Business Standard newspaper
