InvestmentsNov 12 2014

News Analysis: ECB needs to stem outflows

twitter-iconfacebook-iconlinkedin-iconmail-iconprint-icon
Search supported by

Mario Draghi’s stimulus measures to weaken the currency and avoid deflation have triggered significant outflows from stocks and bonds in the eurozone, causing concern that a continuing haemorrhaging of assets could undermine the region’s economy.

In the six months to August 2014, €187.7bn (£147.3bn) flowed out of the euro area, the highest level of outflows since 1999, according to European Central Bank (ECB) data. This sent the euro down to $1.25 on October 3, the biggest decline for two years. But while a weaker euro should help exporters, could ECB president Mr Draghi’s latest policy of buying asset-backed securities go too far?

Darren Ruane, head of fixed interest at Investec Wealth & Investment, believes it is difficult to directly link the recent and potential future policies of the ECB with outflows from European assets.

He says investors may be responding to the European Union’s (EU’s) lower growth trajectory and there are many benefits to the European economy of moving towards an easier monetary position, including neutralising disinflationary forces and boosting exports.

“Over the past few years, the major global central banks have been engaged in a ‘race to the bottom’, with the exception of the ECB,” Mr Ruane said.

“It is unlikely, in the current economic environment, the ECB would complain too much about a materially weaker euro.”

Holger Fahrinkrug, chief economist at Meriten Investment Management, the German investment boutique of BNY Mellon, attributes recent outflows to the recovery in the US and thinks the next move there will be higher, rather than lower, interest rates.

Meanwhile, he sees the successful completion of Europe’s asset quality review and bank stress tests, coupled with speculation that the ECB might intensify its asset purchases, as reducing the likelihood of a downward spiral.

Richard Scrope, manager of the IWI Oriel European fund, also attributes recent outflows to the interest rate differential in the UK and US, especially as the economies in both regions are somewhat stronger. But he believes the ECB has to strike a balance between helping make exports more competitive, thus stimulating recovery, and not weakening the euro to an extent that its trading partners react aggressively.

“Reaching a compromise on the Transatlantic Trade and Investment Partnership is probably more likely to stimulate the recovery, than covert currency intervention.”

So could excessive shorting of the euro or a sell-off of euro-denominated assets create a self-fulfilling downward spiral?

Mr Ruane believes investment flows are only one aspect of explaining movements in currency markets. He says currency values are also decided by variables, such as changes in interest rate expectations, news of liquidity injections (such as quantitative easing) and trade flows.

Mr Fahrinkrug also dismisses the likelihood of a downward spiral, saying financing conditions have improved significantly and the ECB’s “threat” to buy risk assets in large amounts, if the situation worsens, should protect the markets against major sell-offs.

With hardly any “safe” investments anywhere in the world, he doubts investors would turn their back on the region “in a destabilising manner”.

The ECB’s quarterly lending survey showed a small net percentage of eurozone banks reporting an easing of terms on loans to companies, the second quarter in a row this has happened.

So what are the pitfalls of Mr Draghi’s policies?

Mr Ruane believes the greater concern is that Mr Draghi fails to achieve the ECB’s core aim of arresting disinflationary forces in the eurozone. “Many investors are worried the eurozone could move towards the deflation experience of Japan of the past 20 years,” he said.

“A weaker euro, leading to higher inflation and better economic growth, is an easier set of circumstances for a central bank to deal with, than the current challenges of weak growth and inflation.”

Mr Fahrinkrug says the ECB’s dilemma is the euro area’s economic woes have structural roots, which essentially require national, government-initiated responses, such as supply-side reforms, potentially coupled with more growth-supportive fiscal policy.

He says the lack of determined government reform in some EU countries and an unwillingness to use national fiscal leeway to support the union in others, means the ECB feels obliged to act as “policy agent of last resort”.

The main risk associated with this approach is that it reduces the pressure on governments to tackle the deep-rooted structural problems that hamper growth, he says. “If reforms are put off because of this, the slow-growth and low-inflation pattern of the euro area economy will persist, with a permanent risk of tilting over into a deflationary spiral.”

By contrast, Stewart Cowley, Old Mutual Global Investors’ investment director for fixed income and macro, says Mr Draghi’s policies do not go far enough, but questions what tools remain in the ECB toolbox.

“When you have zero/negative interest rates and a European-style, quantitative-easing programme of unknown size directed at the wrong place in the economy, what have you left than to devalue?” he asks.

His main concern is that the ECB is focusing on creating consumer loans, rather than directing credit to small to medium-sized enterprises. Loans to SMEs by the European banking system have shrunk by €600bn since the crisis.

Mr Cowley thinks the ECB’s current securitisation programme may not work because of the “sclerotic”, middle-tier banking system in Germany and Italy.

“At some point, the ECB will have to do one of two things: either target actual companies, which means transferring risk inside the ECB, and/or Germany and others will have to be brought to the table and told: ‘We’ve got to relax some of the budget deficit rules and allow governments to start borrowing again’,” he says.

“I see this [recent ECB moves] as the first baby step on a longer journey.”