The ECB’s easing package announced in June has more than met the market’s expectations. While the rate cuts were expected, it is the announcement on targeted longer term refinancing operations (TLTROs) that is most significant.
But the success of the TLTRO programme, which allows banks to borrow funds for up to four years at 0.25 per cent, will be measured on whether it stimulates bank lending to the non-financial private sector. Specifically, the ECB wants to encourage more lending to corporates, especially in the periphery.
The TLTRO is structured to give banks a large incentive to participate. Four-year funding at a fixed rate of 0.25 per cent is well below where even the strongest banks can obtain funding in the market. The hope is that they will use the new, cheaper funding to increase lending to small- and medium-sized enterprises (SMEs). However, there is nothing explicit in the conditions that will prevent banks from using the funds to buy sovereign bonds. Banks are not eager to expand lending in the current macroeconomic environment, while demand for loans also remains weak.
It is expected that the TLTRO’s impact on the real economy will be limited and the ECB could take additional measures at a later stage. One problem is that the TLTRO will not completely offset the decline in liquidity resulting from the maturation of the old long term refinancing operations (LTRO).
European banks, mostly Italian and Spanish, need to repay roughly €500bn (£294.7bn) of the old LTRO borrowings by February 2015. The new TLTRO will replace up to 80 per cent of that money, based on the requirement that banks can borrow no more than 7 per cent of their loan book (excluding public sector and mortgage loans) as of April 2014.
Other types of ECB liquidity - for example, seven-day and three-month borrowing instruments - may cover some of the shortfall, but the ECB’s balance sheet is not expected to expand and should remain at a stable level.
Therefore the Governing Council is unlikely to consider any new policy measures until after the TLTRO is complete in December and the asset backed security (ABS) purchase programme is operationalised.
Mario Draghi has stated that additional rate cuts are unlikely. Significant quantitative easing (QE) – buying government bonds – will probably be implemented at some point, although it is unlikely to be this year. Some ECB members still have ideological objections to buying government bonds, so QE is not a fait accompli. Nonetheless, this latest easing package allows the more dovish ECB members to show the hawks that they have tried everything else so that they can start to contemplate QE.
The latest ECB announcement is not a panacea. Rate cuts should help to anchor euro rates at a low level as the Federal Reserve and the Bank of England move closer toward implementing interest rate rises. But the healing of the eurozone economy will take time and it remains in a vulnerable state. Japan has showed how difficult it can be to escape the virtuous circle of low growth, low inflation and high debt.
Ken Orchard is portfolio manager of the T. Rowe Price European Fixed Income fund
