Markets sighed with relief as the ECB finally seemed to be addressing the growing deflationary risk in the eurozone.
“The way they tackled the problem, although delayed, was fairly clever,” Orchard says. “Domestic demand has been so weak, the eurozone needs eternal demand to support the economy and a weak euro is the way to deliver that.
“Earlier this year, when the euro was pushing €1.40 against the dollar, markets were questioning why Draghi wasn’t acting sooner,” he continues. “It is now trading around €1.25, which will be a fairly big help to a lot of eurozone companies, especially in Italy and France.”
THE BAD…
But disappointment soon followed as Draghi shied away from setting definitive numbers on how much the central bank might buy in its efforts to boost credit and stave off deflation. Markets had been hoping for a very large amount of purchases or even the addition of sovereign debt purchases.
Expectations of full-blown quantitative easing in the form of sovereign bond purchases have grown in recent months as the unconventional measures undertaken by the ECB so far fail to address anaemic credit growth.
The hope had been that the TLTRO and asset purchasing programmes would work in unison to boost lending, providing support to the real economy. Banks are effectively able to borrow money at very low (and even negative) rates without taking on too much credit risk or needing too much liquidity, which could then be lent to the private sector before being repackaged as asset-backed securities and resold to the ECB – and so the cycle continues.
But so far, it has proven very difficult to get banks or their clients borrowing again.
“The problem is in the transmission mechanism,” according to Aviva Investors senioreconomist Stewart Robertson. “All actions to date have been good, but they have all been credit rather than quantitative easing. They have been designed as an incentive for banks to lend to the real economy, but no matter how powerful those incentives are, they still rely on banks wanting to lend and customers wanting to borrow.”
While banks grapple with the dual pressures from the ECB and the need to maintain capital ratios in line with the new regulatory environment, loan demand has remained fundamentally weak. Companies and households are still very cautious, with little belief in the positive economic story, and debt levels that are still high.
As RMG Wealth Management CIO Stewart Richardson says: “Those that want to borrow don’t have a good enough credit rating, and those that do, don’t want to borrow.”
The challenge for Draghi is now how to get money flowing into the real economy as current measures prove unfit.
“This is exactly what QE attempts to do; bypass the banking system,” Aviva Investors’ Robertson states. “The current measures are not enough. The ECB is tiptoeing in the right direction, but needs to take a big step. If if doesn’t succeed in turning sentiment around, the only place to go is outright QE, which is likely where they are heading in second or third quarters of next year.”
Some, like RMG’s Richardson, believe it could come as soon as Q1, but it is clear things will have to get worse before they can get better.
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