James Bevan: ECB and the euro

Over the course of his prepared comments during last week’s monetary policy statement, Mario Draghi, president of the European Central Bank, explicitly stated that credit conditions were improving in Euroland but at the same time he held out the prospect of yet more QE before the end of the year.

Skipping the implied inconsistency in this statement, actually there’s scant evidence of improving credit growth, with household sector credit growth stuck at the same 1.6% annualized rate for the last year or more, while the volume of bank lending that is outstanding to the non-financial corporate sector is in fact falling.

Even if we include corporate bond issuance, there’s been no net increase in corporate sector borrowing in Euroland since QE began – and the year-on-year data may look better as a result of a weak base effect and a one-off strong month in the data during the first quarter.

Meanwhile monetary growth has also softened over recent months on a sequential basis and therefore we can argue that more QE is already required.

Explanations

It’s hard to explain just why Euroland corporate bond issuance is so weak at present. In the US, corporate bond issuance has of course surged to what are probably uncomfortably high levels under the Fed’s QE regime, but this simply has not occurred in Europe.

This may be because companies are simply in a deleveraging mode, or it may be because the principal buyers of European corporate bonds have historically been the commercial banks who may now simply want to shrink their balance sheets for regulatory reasons.

Whatever the cause, it does seem beyond all reasonable doubt that QE has not led to stronger borrowing trends in Europe and particularly not within the corporate sector.

Another entirely plausible reason why the ECB might wish to expand QE might be to weaken the euro further. Mr. Draghi was at pains to point out that the fall in the oil and commodity prices had benefited Europe’s economy. But there needs to be a weaker euro to support traded goods producers. Much of Europe’s H1 2015 recovery can be traced back to the fact that the oil price fell by more than the Euro, thereby providing the domestic economy some insulation from the real income diminishing effects that normally accompany a devaluation. The region was able to enjoy the benefits of a weaker currency without suffering too many of the costs.

We can’t, of course be sure, however, that more QE will deliver a weaker euro given that at present, Europe’s running a current account surplus of some €300bn per annum and although this surplus has probably peaked, this does support the currency.

At the same time, Europe’s non-bank private sector is fairly consistently each year purchasing around €350bn of foreign bonds and around €50bn of foreign equities. A year or so ago, Europe’s banks were acquiring around €500bn of foreign credit exposure each year, but this has now started to reverse and may even have become a €100bn flow of repatriated funds.

These various ‘domestically orchestrated’ flows (i.e. the current account plus these various capital flows) were last year biased towards creating a weaker euro but the reversal in the direction of the banking system flows (i.e. “carry trade flows”) has created a situation in which the balance of domestic flows is roughly zero and therefore close to Euro ‘neutral’.

Future directions

Therefore, we can suggest that the future direction of the Euro will tend to be decided by the actions of foreign investors into Europe.

At present, foreign investors are relatively inactive in terms of their level of equity purchases, although they had previously been very active in the run up to QE.

Similarly, foreign investors were also very active as purchasers of European bonds in the run up to QE but since May they have become net sellers of bonds, presumably taking profits on their existing positions.

We must wonder, however, whether, with the ECB now promising more QE, lower yields and perhaps higher equity prices, foreign investors will once again begin acquiring Euroland assets.

If this occurs without a compensating further increase in the quantity of purchases of foreign bonds and equities by European real money investors, the result of the rumours of more QE will likely be a stronger rather than weaker EUR, at least for now.

Thus in 2014, the euro was in effect held down despite foreign investor inflows and the current account surplus by a combination of very large, but consistent, capital outflows by non-bank European investors and large outflows from European banks.

But with the latter now unlikely given  the regulatory environment, there may be insufficient outflows from Europe to offset the combined effects of the current account surplus and any renewed interest in Europe’s markets from abroad.

If the level of outflows from European investors does remain at the reasonably stable €400bn level seen for the last year or so, it’s likely that this will prove to be insufficient to offset the combined effects of any QE-related increase in foreign capital inflows, the ongoing current account surplus and the European banks’ repatriation of their foreign assets.

Under this scenario, the euro should tend, somewhat counter-intuitively, to appreciate, although in theory, the ECB could potentially undertake FX intervention to weaken the euro.

Stimuli

In practice, we can doubt that the ECB would or could enact such a provocative and overt competitive devaluation policy ahead of the US elections with no sign of ECB direct intervention in FX markets since the global financial crisis and changes in the level of the ECB’s holdings of FX reserves have resulted from the euro’s volatility.

Given the ongoing weak global economic environment, the question marks that remain over the future of Greece and the obvious lack of monetary traction that the ECB has so far achieved, it’s easy to see why Mr. Draghi has been obliged to talk up the prospects for further stimulus from the ECB. The euro does, after all, still face a simmering existential crisis.

However, if Mr. Draghi’s actions do result in a weaker euro, then he will be explicitly adding to global deflationary pressure, which may prove self-defeating for the ECB in the longer term.

But if the rumours of more QE lead to a counter- intuitive rise in the euro in the near term, then we may find that while Mr. Draghi inadvertently relieves some of the global deflationary pressures, this will come at the expense of Europe’s own traded goods producers.

On this form of cost-benefit-analysis it is difficult to see why more QE would be a good idea under either scenario.

What’s more, the ECB’s adoption of its existing QE has already caused an increase in the stresses within the TARGET2 system, while doing virtually nothing to improve underlying domestic monetary trends.

Consequently, we can argue that the case for more QE is far from proven, and actually very weak. But this’ll likely be ignored by markets for a while although over the longer term, the bottom line remains that the euro is a sub-optimal currency area that badly needs structural reform.

What it does not need is more ‘money printing’ that gives its political masters another excuse not to tackle the region’s fundamental problems.