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European Perspectives
May 2013
Myles Bradshaw
Your Global Investment Authority
How to Turn the ECB
Straggler into a Central
Bank Pacemaker
Myles Bradshaw
Executive Vice President
Portfolio Manager
Mr. Bradshaw is an executive vice
president and portfolio manager in
the London office. His main focus
is European macro strategy and in
particular the evolution and investment
implications of the eurozone sovereign
debt crisis. He is also a permanent
member of the European Portfolio
Committee. Prior to joining PIMCO
in 2007, he worked at Threadneedle
Investment Managers for six years,
managing global and sterling bond
portfolios. Mr. Bradshaw started his
career as an economist at HM Treasury,
where he worked for three years. He
has 14 years of investment experience
and holds an undergraduate degree
from Oxford University.
The U.S. Federal Reserve (Fed), Bank of Japan (BoJ)
and Bank of England (BoE) have all been heavily engaged
in asset purchases. The European Central Bank (ECB),
in comparison, looks like a shrinking violet. As of 13 May
2013, the Fed’s and BoJ’s balance sheets have grown yearto-date by 14% and 10% respectively; the ECB’s balance
sheet actually fell by 14%.
How central banks use their balance sheet is also important: Asset purchases
are 10% of the ECB’s balance sheet, but 97% of the Fed’s. The ECB has
provided funding support but, in contrast to the Fed, has transferred much
less risk from investors’ balance sheets. The result is that it has done less to
help banks deleverage, improve their capital ratios and hence increase their
willingness to lend.
Investors should be wary of extrapolating this status quo – Europe’s weak
economic outlook means that we should expect the ECB to become more,
not less, engaged. The response is likely to remain fitful, switching from
“Whatever It Takes” (WIT) to conditional support. We have already seen this
with the ECB’s Outright Monetary Transaction (OMT) programme which was
conceived as unlimited support to tackle “convertibility risk” but has been
diluted to a conditional programme as sovereign spreads have tightened.
Macro outlook suggests the ECB will need to act on the basis of
“price stability”
The mid-point of the ECB’s GDP forecast, -0.5% in 2013 and +1% in 2014,
is in line with consensus. And this implies that the eurozone will return to
trend growth toward the end of 2014.
5.0
4.0
3.0
2.0
1.0
0.0
-1.0
-2.0
-3.0
Mar
‘10
Mar
’11
Mar
’12
Mar
’13
Mar
’14
62
60
58
56
54
52
50
48
46
44
42
PMI Output
Actual QoQ GDP
Consensus
EuroCoin Coincident GDP indicator
Source: Bloomberg, Eurostat, Markit, Banca D’Italia as of 15 May 2013
The ECB’s own assessment is that growth will strengthen as
exports grow and ECB monetary policy supports eurozone
domestic demand. But it is difficult to see how monetary
policy can work when the transmission mechanism remains
broken. Figure 2, which shows the divergence in the cost of
credit for eurozone small companies, reminds us that the
eurozone policy response has still not fixed the monetary
transmission mechanism.
Without much needed growth, the risk that inflation undershoots the ECB’s definition of its price stability mandate,
“close to but below 2% inflation”, rises. The eurozone’s
annual Consumer Price Index (CPI) fell from 1.7% to 1.2%
in April 2013 (according to Eurostat). While some of this
may reflect the timing of Easter, it is also worth noting that
the ECB’s own forecast is for low inflation: 2014 mid-point
is 1.3%.
The macro data suggests that the ECB may now start to use
its balance sheet more proactively to target growth and
inflation. With that in mind, what might the ECB do next?
2 May 2013 | European Perspectives
7.0
6.5
6.0
5.5
5.0
4.5
4.0
3.5
3.0
2.5
Jan
‘08
Jul
‘08
France
PMI (%)
Percent (%)
FIGURE 1: ANNUALISED EUROZONE QUARTERLY
GROWTH RATES
FIGURE 2: INTEREST RATES ON NEW CORPORATE LOANS
FOR LESS THAN €1 MILLION
Percent (%)
The macro data suggests that more needs to be done to
boost confidence to secure the forecast economic recovery.
Figure 1 shows that, despite improving financial conditions in
the eurozone, Banca D’Italia’s EuroCoin estimate of GDP and
the Markit Eurozone PMI survey remain consistent with
recession in Q2 2013.
Jan
‘09
Jul
‘09
Jan
‘10
Germany
Jul
‘10
Jan
‘11
Italy
Jul
‘11
Spain
Jan
‘12
Jul
‘12
Jan
‘13
Eurozone
Source: European Central Bank as of January 2013
Further rate cuts are highly likely
European banks have been repaying ECB long-term
refinancing operation (LTRO) borrowings at a €6.5 billion
weekly pace since April 2013. At this rate, excess liquidity
will be below €200 billion this October 2013 (see Figure 3),
a level that in the past coincided with overnight money market
rates beginning to move away from the ECB’s 0% deposit rate
and towards the ECB’s 0.5% main refinancing rate.
FIGURE 3: ECB OPEN MARKET OPERATIONS – EXCESS
EUROZONE LIQUIDITY (IN € BILLION)
1,200
1,000
800
600
400
200
0
Sep Oct Nov Dec Jan
‘12 ‘12 ‘12 ‘12 ‘13
Feb Mar Apr May
‘13 ‘13 ‘13 ‘13
Main Refinancing Operation
Excess Liquidity
Jul
‘14
All LTRO’s
Projected Excess Liquidity
Source: European Central Bank, PIMCO as of 15 May 2013
A further interest rate cut therefore seems likely as we believe
the economic outlook does not warrant an endogenous
tightening in ECB monetary policy. But this is not an
incremental monetary stimulus.
Fixing the transmission mechanism
Mr. Draghi has stated that the fragmented transmission
mechanism started with the sovereign debt crisis. He has
asserted that some of this fragmentation reflects issues
beyond the ECB’s control, specifically the lack of bank capital.
But this is a weak argument for why the ECB should not
address parts of the problem that reside within its realm
of influence.
First best solution: A political non-starter
As recently as March 2013, Mr. Draghi asserted that credit is
expensive in Europe’s periphery because local banks “…buy
[high yielding] government bonds, or lend to the private
sector at a much higher rate than the yields on government
bonds.” He went on to say that normally, banks in other parts
of the eurozone “…would take the opportunity to either buy
other countries’ government bonds themselves, so that the
yields on those bonds would go down, and the domestic
banks would then have more incentives to lend to the
private sector… .”
The direct way for the ECB to address this problem would be
to intervene and lower the relevant government bond yields.
Legal arguments are probably overblown: European Union
(EU) treaties have not prevented the ECB from buying
government bonds. The key political constraint is that large
scale ECB purchases would represent a form of eurozone
debt mutualisation. Germany, as the largest and most
creditworthy ECB shareholder, would likely become more
engaged in under-writing peripheral credit risk elsewhere.
This has implications for ECB political independence,
something the Fed does not have to worry about. It is also
something Germany is resistant to unless accompanied with
greater controls over the conduct of peripheral fiscal policy.
Second best-solution: Lower banks’ funding costs
to reduce the cost of credit
The ECB has initiated discussions with other European
institutions to promote a functioning asset-backed securities
(ABS) market, raising the prospect of ECB credit easing. While
quantitative easing (QE) seeks to encourage more risk-taking
by lowering the potential return from owning perceived
“safe assets”, credit easing is an attempt to lower the cost
and increase the provision of credit directly.
However, unlike the U.S., European credit is intermediated by
the banking system and remains on banks’ balance sheets.
Without an active securitisation market, there are few “risky”
instruments that the ECB can buy.
Developing the ABS market will likely take some time. Gross
public ABS issuance is running at €20 billion in 2013, down
from €325 billion in 2007. Even in the “good old days”, ABS
was only common in some national markets: Spain,
Netherlands and UK accounted for 53% of 2007 publically
distributed ABS issuance (Source: J. P. Morgan, 13 May 2013).
Creating a harmonized set of ABS regulations and transparent
data for different national markets will involve difficult
negotiations with a variety of national and regional bodies.
We should not expect rapid progress and should not be
surprised if the ECB changes tack and buys other private
assets, such as banks’ loans, or allows national central banks
to create national schemes. Even making it easier for banks to
repo a wider variety of ABS at a lower hair-cut should help by
reducing peripheral banks’ dependence on more expensive
senior unsecured bond market funding.
Details matter, but a well-designed asset purchase
programme could help banks deleverage
To have a meaningful impact on the broken transmission
mechanism, any ECB programme needs to lower the cost of
credit in the most affected economies: peripheral Europe. This
could potentially be achieved by creating a programme that is
regionally tailored or big enough if assets are purchased on a
prorate basis.
European Perspectives | May 2013 3
Purchasing private assets could directly lower the cost of
credit for borrowers in peripheral economies and have
significant positive indirect effects. Banks could either use
the proceeds from asset sales to buy other high yielding
assets, such as peripheral government bonds, or reduce their
reliance on wholesale financing, i.e., reduce the supply of
high yielding senior bank bonds.
More importantly, purchasing private assets could help the
European banking system to further deleverage. To do this,
the ECB, or some other European institution, must go beyond
simply providing funding support that occurs when banks
repo bonds at the ECB or sell super-senior ABS tranches.
Instead they must engage in some form of risk transfer. For
example, if banks sold whole loans or the subordinated part
of the ABS capital structure, they could reduce their riskweighted assets and hence raise capital ratios. This could be
the most powerful way to increase banks’ willingness and
ability to lend.
Negative interest rates: A less effective form of QE
with greater risks
Mr. Draghi has raised the possibility of cutting the ECB’s 0%
deposit rate. Such action would probably push short-dated
market rates into negative territory, effectively charging
global investors for holding euros. Consequently, we’d
expect a weaker euro, which would be stimulatory for the
entire eurozone.
negative interest rates, although we believe a negative
25 basis points penalty would probably be manageable.
Super-long LTROs not a game changer
Given the technical difficulties of an ABS purchase program
and uncertain consequences of negative interest rates, the
ECB may opt for doing more of the same. A super-long, for
example 5-year, repo operation, or regular 3-year LTROs,
would be technically much easier to implement than
asset purchases.
A more regular provision of multi-year ECB liquidity might
encourage some banks to increase their leverage and seek
to earn more carry from buying longer-dated and risky assets.
But it would likely be difficult to sustain this given the
deleveraging demands of both markets and regulators.
The recent fall in risk spreads suggest that the market’s
perception of liquidity risks is currently relatively low. So it’s
not clear that risk premiums would fall much if the ECB
sought to lower liquidity risks further by implementing a
regular multi-year ECB repo operation.
Conclusion
The technical difficulties in creating an asset purchase
programme and the consequences of cutting deposit rates into
negative territory suggest that designing new non-standard
measures will take some time. But without a pick-up in business
confidence, the likelihood of more ECB action will increase.
Negative ECB deposit rates could at the margin make
peripheral assets relatively more attractive to investors.
But it would be a surprise if a 0.25% penalty were enough
to fix the transmission mechanism. A broken transmission
mechanism implies that investors have become unresponsive
to small changes in relative prices. This suggests policymakers
need to do more than simply tweak relative prices further.
In our opinion, the ECB will be most effective if it can design
a programme that helps banks deleverage more quickly
rather than simply providing cheaper funding. Unfortunately,
the political obstacles suggest that the ECB’s response will
probably continue to be “too slow or not quite enough”
to tackle the low growth outlook.
Negative interest rates could also have significant unintended
consequences. The negative impact on the eurozone’s money
market, pension, insurance and repo industries are difficult
to quantify but could be potentially significant. Core country
banks’ net interest margins would also be depressed by
More unconventional ECB measures may help maintain the
wedge that has developed between the valuation on risky
assets and the economic growth prospects. But we believe
long-term investors should remain focused on the quality of
issuers’ balance sheets rather than simply taking more risk
because of lower prospective returns.
4 May 2013 | European Perspectives
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