Will European QE Work?

Economic analysis by Filipe R. Costa

You can now read in the press that European quantitative easing is already working, as the equity markets are rising and bond yields are at record lows. But that is a very narrow view of what QE really does. While constituting a large-scale asset purchase programme, QE is not designed to create financial wealth as its ultimate goal, but rather to boost real investment, real growth and of course inflation.

In buying assets, the central bank expects to increase the wealth of those who own assets, improve external trade through a weaker currency, reduce borrowing costs, lead to a portfolio rebalancing towards more risk, and so on, in expectation that these effects can pass through several channels until hitting the real economy. High equity prices and low yields are a small part of the effects and are only valuable if the process doesn’t stop there. We want companies and banks to take advantage of lower yields to increase borrowing; we want investors to spend part of their extra wealth; we want companies to use the higher equity values as collateral to borrow for new projects and to hire more. If this wealth does not translate into real growth, and stops at high equity values, then it would have been much better to just do nothing, as the central bank intervention would have simply resulted in a massive redistribution of wealth from society as a whole to the rich, who own most of the real assets.

On 22nd January, the Governing Council of the ECB, headed by its President Mario Draghi, announced what everyone was expecting, a European version of quantitative easing. Even though the final programme was fine-tuned to the upside amounting to a monthly purchase of 60 billion euros per month instead of the widely expected 50 billion, most of the expected effects on bond yields were so largely priced in at that time that the effect on sovereign debt yields since the announcement has been muted. The programme starts in March and is expected to last until September 2016, for a total of 1.1 trillion euros in asset purchases.

Before anything else, I see QE as a way of improving credit markets conditions. It lowers bond yields and thus reduces borrowing costs for companies. At the same time it improves banks’ liquidity, allowing them to increase lending to the economy. If everything goes as expected, the extra supply of credit should find its way through the economy. The exceptional low interest rates should increase the net present value of projects and seduce borrowers. At the same time, these lower rates also decrease the incentive to save and thus push consumers into a buying spree. But the evidence tells us a different story. The ECB has been improving liquidity with securities programmes, covered bond purchases, extensions on its LTRO program, waiver provisions on collateral, and so on. But while there were many takers for this liquidity in the past, recent action shows a lack of demand. The ECB is finding it increasingly difficult to allocate in full the funds offered in its liquidity-providing operations. Consequently, banks now have excess liquidity and don’t know what to do with it. The tightening of banking rules has led to a deleveraging process in Europe, which was aimed at improving banks capitalisation. At first, banks were in need of liquidity to improve their balance sheets, but now they are in good shape again, they no longer need it.

Now that balance sheets are repaired, the main goal of liquidity-providing operations is to provide liquidity to banks for them to lend more. At very low rates banks should take liquidity from the ECB and lend to the economy at slightly higher (but still low) rates. But the tight rules introduced after the financial crisis reduced the appetite to lend, as banks need to hold a very sound portfolio, thus making them extremely “picky” regarding clients. At the same time the fiscal austerity is scaring away any borrowers, be they consumers or companies. Consumers either don’t have a job, have a job but don’t know whether they will keep it until the following day, have at least one family member without a job, or are scared to death by the news. Companies do not expect demand to increase for the next few years and thus don’t feel the need to hire or to invest in new projects, thus free money is used to replace equity for debt and to pay a massive dividend to investors through share repurchases. Under such conditions, liquidity is as valuable as bikinis are in Siberia. In this sense, the massive purchase of assets by the central bank would be similar to sending a container of bikinis to Siberia. The main underlying reason why people don’t use bikinis there is the cold, not the lack of bikinis. So, transposing the analogy to the credit market, I find it difficult to see how extra liquidity would help. The credit channel is broken because of the underlying conditions, which derive much from the current austerity measures.

But, under the underlying conditions the ECB has trapped itself in, it is not only the effectiveness of the credit channel that is at stake. I also doubt the practicability of the programme.

This is not only a matter of banks not willing to lend or lacking willing borrowers, it is also a matter of the ECB being able to put the plan into action effectively. The ECB is willing to buy 1 trillion euros in assets to deploy its QE programme, so there must be someone selling at the other side. When the BoE and the Fed started purchasing assets, the yields on sovereign bonds were at least double the current implicit average yield on European debt. At the same time, equity valuations were very depressed. This provided some scope for price rises in both markets without going out of bounds. But the yield on a 10Y government bond is now around 0.36% in Germany, 1.60% in Spain, and 2.56% in Portugal. At the same time, the Euronext 100 and the Dax indices are up 44% and 95% respectively over the last 5 years. At these levels, the ECB action, if possible in practical terms, will most likely lead to a bubble and, ultimately, the next financial crisis.

But here I stress the words at the end of the previous paragraph: if possible. A few months ago, the ECB turned its deposit rate into a tax. Banks keeping their excess reserves at the ECB have to pay an interest rate of 0.2%. In practice, the ECB buys bonds from the banks, who then deposit the proceeds at the deposit facility earning a negative interest rate, as they lack lending opportunities. Under such conditions, I wonder whether it wouldn’t be better for the banks to keep the bonds and receive a positive income until maturity instead of selling them to the central bank in order to earn a negative rate. They bought these bonds well before the QE announcement and are earning a risk-free income. Why turn it into a negative income? It seems to me that these bonds are now highly valuable in a relative sense and that the central bank will find it very tough to buy them. In the end, the credit channel effect deriving from QE will fail.

Now let’s turn to something else – the exchange rate and foreign demand. The euro has been falling at a stunning pace, which helps the net exporter countries, like Germany. This is a kind of beggar-thy-neighbour policy, which is particularly effective when there’s no one else doing the same thing. But that’s not the case, is it? Everyone, but the UK and the US, is trying hard to prevent currency appreciation. Japan, China, Switzerland, Denmark, and now Sweden: all are engaged in currency debasement of some form or another. No one wants to lose competitiveness and import deflation from their neighbours. I would say that the exchange rate channel will deliver some positive effects but those are limited in time and benefit only the countries that are less in need of QE, as is the case with Germany.

To conclude, it seems that the wealth channel remains the most powerful transmission channel for QE. No matter how much the ECB could buy, the extra demand will press yields down and entice investors to buy more equities. This raises a moral hazard issue of people taking on too much risk, which in my view is much more significant than it was in the US and in the UK due to the current valuations. Lastly, let’s rewind a little to the beginning of this blog. We are at risk of QE serving only to increase the price of equities and bonds with the positive effects stopping there. That would result in a massive redistribution of wealth without much success in reflating the economy. Not that I believe that QE is the best route to follow, but if that is what Europe wants, then at least do it right. The only way for QE to be effective is for it to be mixed with expansionary fiscal policy, otherwise Europe will face the biggest financial bubble ever. A fiscal expansion would allow for some economic growth and attract real investment and in this way fix the credit channel and help prevent a major disconnect between financial markets and the real economy. Alternatively, I would say that, under a scenario of fiscal tightening, it would be much better to avoid QE.