ECB Stimulus: A Bold Move or Baby Step?

European-Central-Bank

The bold financial stimulus package announced by the European Central Bank (ECB) in early June aims to lift the European Union’s depressed economy with cheap loans for private businesses while stanching fears of deflation. According to Wharton faculty, the stimulus is a signal that the ECB is committed to lifting the EU’s fortunes, and they predict that U.S. businesses will benefit from increased demand from the region. However, they note that additional strong measures likely will be needed to help the euro zone bounce back.

On June 5, the ECB reduced its main lending rate from 0.25% to a record low of 0.15%. That would enable banks across the euro zone to borrow more cheap funds from the ECB. In another measure to increase liquidity, it cut its overnight deposit rate for commercial banks from zero to minus 0.1%. Effectively, that means banks would have to pay the ECB to accept their deposits. The ECB also said that later this year, it would provide banks with low interest loans of €400 billion (about $540 billion) for them to lend to private businesses, especially in the southern euro zone countries of Spain, Italy, Greece and Portugal.

“This latest round of interest rate cuts is a very important moment for Europe, and it is very good news,” says Mauro F. Guillen, Wharton management professor and director of the school’s Lauder Institute. “Most of these countries have been in a recession for four years and unemployment is extremely high, so it is important to provide as much support for the economy [as possible].”

According to Wharton finance professor Joao F. Gomes, the interest rate cut has a “larger symbolic value,” but it is likely to have limited success in arresting low inflation. “It reinforces the perception that the ECB is fully committed to fostering an economic recovery in the euro area,” he says.

Further, the ECB moves reinforce the view that “[interest] rates will be low for a very long time,” Gomes notes. “In the best-case scenario, it helps push long-term bond yields lower and the euro, too,” he says. Since the stimulus announcement, the euro has fallen against the dollar from €1.37 on June 5, when the ECB unveiled its stimulus program, to €1.35 on June 17. It is also down from this year’s high of €1.39 on May 6.

A Question of Impact

The ECB’s plan to provide €400 billion in cheap loans is unwise, according to Guillen. “I am not in favor of special kinds of deals for particular types of companies, so I am not a big fan of this kind of [cheap loans] program,” he notes. “I understand it is important to do something, but … it is better to do things that will benefit everybody,” such as lowering interest rates or buying government bonds, he says.

Gomes agrees. “[Loans] might help at the margin, but it is hard to see [them] making a big difference.” The ECB had resorted to similar moves earlier. In 2011-2012, it lent €1 trillion ($1.35 trillion) in cheap funds, but with limited impact. Banks may not jump at the offer of cheap loans, Gomes adds. “Banks in Southern Europe are very worried about repayment risk and exposure to further capital losses right now. [Reducing] financing costs [by a few basis points] is not enough to significantly change the basic dynamics of lending.”

“I am not in favor of special kinds of deals for particular types of companies, so I am not a big fan of this kind of [cheap loans] program.” –Mauro F. Guillen

Gomes notes that concerns about the lack of lending to small businesses are much more serious in southern Europe than elsewhere in the region. In addition, many southern European banks continue to have “very weak balance sheets,” he says. If banks see private businesses in southern Europe as less creditworthy, “that is a reflection of the weak economy,” he explains. “They are struggling with weak demand and low incomes.”

According to Gomes, what the ECB fundamentally wants to do is to encourage banks to lend more and increase their risk appetite. “[The ECB views] conservative bank lending as a severe constraint to consumption and especially investment in many parts of Europe,” he says, adding that while the ECB has “changed the incentives to lend at the margin,” its main goal was “to restore confidence in the economy and try to guide asset markets.”

Gains for U.S. Companies

For the most part, however, the ECB moves are “good news” for U.S. firms, Guillen notes. “Many American firms make very important proportions of their profits in Europe,” he says, pointing to the automobile, consumer goods and financial services industries as examples. “If the European economy – the second largest market in the world – continues to be depressed, that means that American companies won’t be able to sell as much.”

Specifically, the ECB’s interest rate cut will help U.S. firms for two reasons, according to Guillen. “One is that the European market will expand, and U.S. firms will be able to sell more there. Secondly, if Europe manages to start growing again, a lot of the uncertainty that exists in global markets will disappear.”

While it may take three or four months to see how the stimulus program begins to yield results, it is important to track expectations, says Guillen. If the ECB moves help to change consumer and investor expectations that the European economy will become stronger, “that could have an impact much earlier,” he notes.

Gomes warns against predicting too many gains for U.S. businesses from the ECB stimulus. “Fundamentally, anything that encourages growth in Europe is good for the U.S., particularly for exporting firms,” says Gomes. However, he feels it would be wrong to assume that U.S. firms — excluding banks — will have any competitive advantage in doing business in Europe. “If European consumers are not shopping, it doesn’t matter whether you are trying to sell a Ford or a Fiat,” Gomes notes. “And if small businesses are on the verge of collapse, it would be equally risky for a U.S. or European bank to lend to them.”

“If European consumers are not shopping, it doesn’t matter whether you are trying to sell a Ford or a Fiat.” –Joao F. Gomes

However, the ECB moves may encourage European companies to invest more in new capacity and expand into the U.S., according to Yvonne Bendinger-Rothschild, executive director of the European American Chamber of Commerce in New York City. The chamber’s roughly 650 corporate members include U.S. companies such as AIG and General Electric, and European companies such as Pirelli Tire and Societe Generale.

“What we are hearing from the [European] companies that we work with is that they are now ready to invest,” says Bendinger-Rothschild. Until now, many of them were in “a holding pattern … and they weren’t investing in new production,” she notes. European companies are eager to expand into the U.S., now that they have easier access to finance. “They have their investment plans ready and can now take the next step and will need financing to take these steps. The outlook is definitely more positive than it was even a couple of months ago.”

Bendinger-Rothschild notes that above all, the U.S. companies among her members want “a stable EU market. They feel that it will be helpful for the European economy if companies there have access to additional funds, because they then either buy more American products or expand activities in Europe.”

Access to bank finance is a major obstacle on both sides of the Atlantic, she adds. “The issue in the U.S. and in Europe is that banks are not lending [to businesses] and are lending to each other and putting money into their respective central banks,” she notes. “With that, there is not enough money available in the market [for businesses].” Small and midsized businesses in Europe have failed to benefit from increases in market demand for their products because they have been unable to access funding to expand capacity, she adds.

U.S. companies can overcome reduced access to bank funding more easily than their European counterparts can, according to Bendinger-Rothschild. “In Europe, if you need money you go to the banks. In the U.S., if you need money you go to Kickstarter, you talk to an angel investor, you talk to a [venture capitalist] or you talk to a fund.” That array of options is one reason why some European companies are expanding into the U.S., she points out. “They are hoping that it will open them up to additional financing opportunities and access to capital that they may or may not have as easily in Europe.”

From a broader U.S. viewpoint, the ECB stimulus is significant against the backdrop of its widening goods trade deficit with the EU and the work underway in cobbling together a transatlantic trade pact — or the Transatlantic Trade and Investment Partnership (TTIP). Together, the U.S. and the EU account for three-fifths of global GDP, a third of the world trade in goods and more than 40% in services. They also make up about half of all global production, one-third of global trade and one-fifth of global foreign direct investment, notes former democratic U.S. congressman James Bacchus in a column two weeks ago in Forbes magazine. Making a case for the TTIP, he says, “the direct and indirect gains for both the EU and the U.S. from increased trade resulting from such a deal could be enormous.” Citing studies, he says a comprehensive TTIP would annually add $122 billion to the U.S. economy and $150 billion to the European economy.

Too Little?

While the ECB stimulus is welcome news, it is less broad in its sweep than the U.S. Federal Reserve’s stimulus package was, and it should have come much earlier, according to Guillen. “The Federal Reserve has done four times as much as the European Central Bank,” he says.

“What we are hearing from the [European] companies that we work with is that they are now ready to invest.” –Yvonne Bendinger-Rothschild

Guillen notes that the European Central Bank is limited in that it has only one mandate – price stability. The Federal Reserve has both price stability and employment as mandates. He adds that the ECB has been constrained also because many European governments — including those of Germany, Finland and Denmark — were not in favor of a “wholesale stimulus” program, although they went along with the latest stimulus. “The European Central bank is doing belatedly what it should have done three or four years ago — not only to keep the euro together, but also to stimulate growth.”

Already, many are looking at ECB president Mario Draghi’s next move, especially since he has said that the ECB will do whatever it takes to save the euro and that more stimulus measures could follow. “Are we finished? The answer is no. If need be, within our mandate, we aren’t finished here,” Draghi told reporters after the ECB announcement. The bank’s future options include buying asset-backed securities, he indicated.

Guillen agrees that the ECB may be compelled to buy bank assets as a further stimulus. “It depends on how the economy evolves in six months or so,” he says.

Gomes adds that future measures could include “aggressive quantitative easing.” In quantitative easing, central banks buy financial assets from banks and other lenders to increase the monetary base, or the combination of bank reserves with the central bank and currency with the public.

According to Eurostat, the EU’s statistics agency, the annual rate of inflation across the 28-nation region fell to 0.6% in May, approaching levels seen in the 2009 global recession. That has raised expectations that other central banks in the bloc will follow the ECB in providing fresh stimulus to their economies, says a recent Wall Street Journal report.

Meanwhile, despite the ECB’s efforts, geopolitical hotspots around the world — such as Iraq and the Ukraine — might ultimately determine how much of an impact the new stimulus will have, says Guillen. For example, attacks over the past two weeks in northern and central Iraq by the Islamic State of Iraq and the Levant (ISIS) have triggered widespread fears of an energy crisis in the making. Says Guillen: “Energy markets tend to be affected very quickly — and if energy prices go through the roof, that could slow down the economic recovery.”

 

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