James Bevan: Will the ECB’s QE work?

The ECB’s decision to adopt full blown QE with a monthly rate of €60bn reflects their hope that investors will take their newly provided funds and either invest them in the Euroland Periphery either to provide some form of monetary stimulus through the region’s banking systems (unlikely) or more probably via the securities markets. The ECB may also be hoping that some of these funds find their way outside the Euro, thereby orchestrating a competitive devaluation on their behalf, and there are those in Europe that want a weaker Euro exchange rate but worryingly if the dollar does strengthen further, this could not only increase deflationary pressures in the US and elsewhere but it might also precipitate a systemic EM Crisis given the estimated $6tn of carry trades currently in place.

The ECB may deep down therefore be queasy on the euro vs. the dollar, and it will also be concerned if Spanish, Italian or other Peripheral Central Banks buy bonds from existing investors in their respective debt markets and the vendors then simply use the proceeds to move their money into the Core bond markets in some form of deflation trade.  Were this to happen, then the Peripheral countries would be left facing significant deflationary balance of payments deficit positions that would likely force real interest rates higher in these countries and at the same time leave these countries ever-more reliant on TARGET2 funding.

Moreover, if the TARGET2 imbalances were to increase as a result of the ECB’s actions, then it would unravel the ECB’s ‘risk sharing’ efforts because as TARGET2 balances expanded, so secession risks would automatically be transferred to the balance sheets of the core central banks. Perhaps the only practical way that the ECB’s policy actions may not ultimately make the global situation worse would be if most of the money that it creates through its bond purchases flow into and stay in Peripheral economies, and the EUR does not become too much weaker. In order for this to happen, there needs to be belief that the ECB has in fact done enough to stave off deflation and foster what will ultimately become an inflationary recovery.

Lifting the bonnet, we have to be concerned that the ECB may have fallen short on this objective and it emphasized the simple fact that if Europe is to recover full, it needs some help from fiscal policy and most of all from structural reforms – and there was no mention of plans on these fronts. The lack of detail or even comment on complementary policies was significant as was the time devoted to risk-sharing and mutualisation of risk. If Euroland truly was one country heading for the type of fiscal and ultimately political union that would make the Euro a ‘real’ currency, then discussion on risk sharing would simply not have been needed, and the fact that risk–sharing had clearly been a hot topic of debate reveals the ongoing underlying tensions. To make matters worse, the Finns had decided an hour or so before the meeting to voice their objections to any new Greek debt deal, which represents another headwind for the cause of greater European integration and policy credibility.

In conclusion, the all-important question as to whether the ECB’s actions this week will have been sufficient to reflate the Euroland economy boils down to the simple question as to whether the EUR1tn headline number is a big enough statement on its own to Europe’s wider population to offset the technical challenges, the visible lack of EU unity, and the absence of complimentary policies. We may worry that when markets reflect on the details, they may decide that not much has really changed in Europe apart from the amount of money now in play, and the ECB may not have done enough to reverse the recent decline in Euroland expectations, with the risk that the extra funds will be directed either back to the core or directed out of Euroland altogether. Flows into dollars could prove inherently destabilizing for the global financial system but flows into EMs could help those markets in the short term but only at the cost of having made the latter’s appetite for and reliance on capital flows worse in the longer term. If the ECB’s actions result in further significant weakening in the EUR or in further stresses appearing within TARGET2, we will look to adopt a more cautious stance with regard to risk markets.

James Bevan is chief investment officer of CCLA, specialist fund manager for charities and the public sector. CCLA launched The Public Sector Deposit Fund in 2011 to meet the needs of local authorities and other public sector organisations. You can follow James on twitter @jamesbevan_ccla