ECB’s Lagarde is not out of options

04 November 2019, Berlin: Christine Lagarde, President of the European Central Bank (ECB), will give the laudation to President of the Bundestag Schäuble at the “VDZ Publishers’ Night 2019

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First the Federal Reserve surprised the market with a 50-basis point emergency rate cut.

It then took the Bank of England one week to follow up with a shock rate cut of its own, alongside the launch of a new small to medium-sized enterprise (SME) lending scheme and capital alleviation measures for domestic banks.

Attention now turns to the European Central Bank (ECB) in what will be the first big test for its president, Christine Lagarde, the self-proclaimed monetary policy “owl.”

The committee still has an optimistic forecast of 1.1% in GDP (gross domestic product) growth for 2020. These projections will invariably be revised lower and put more pressure on the central bank to fight back against the simultaneous collapse in long-term inflation expectations.

The interest rate market is pricing in a 13-basis point cut this Thursday, but analysts disagree on the utility of a cut given the negative side effects on the profitability of the banking system. 

Should the ECB cut rates, they would likely need to offer an olive branch to the banking sector (which is already down 20% this year in the stock markets). The bank had already introduced a rule back in September which exempts a portion of a bank’s deposits from negative interest rates. The current rate is six times their mandatory reserves — this could be upsized.  

The argument for a cut is that the currency has appreciated about 5% on a trade-weighted basis in the last month, and with the ECB eyeing the Fed over its shoulder (which arguably has more conventional policy left), a rate cut may be on the cards to cap appreciation there.

Other options include: Upping the size of ECB asset purchases from 30 billion euros ($34 billion) a month to 40 billion euros, and increasing technical limits: Currently the ECB can only buy up to 33% of a bond issue. It could hike that limit to 50% to free up more government bonds to buy. Additionally, it could also purchase more corporate bonds alongside the sovereign bonds it purchases.  

But in many ways this is not a conventional shock and using the same medicine prescribed for a financial or sovereign crisis may prove ineffective. The ECB has the tools to target the real economy directly and must use them to help protect businesses most at risk, similar to what the Bank of England announced on Wednesday.

Targeting banks

One option would be modifying the terms of its long-term liquidity operations (TLTROs) directed at euro area banks. Essentially, these involve the central bank lending money at a very low interest rate to banks in the region.

In order for these lenders to be eligible for the preferential borrowing rates, they have to satisfy certain lending criteria. The ECB could make this lending criteria less onerous. One other option, proposed by Unicredit Chief Economist Erik Nielsen would be to introduce a short-term six month bridge facility giving all banks as much cash as they would like to borrow at the ECB’s current deposit rate.

Nielsen also flags the urgency of the situation as current operations are set to expire in June.

Targeting businesses

One other way for the ECB to target businesses affected by the coronavirus-induced shutdown is to offer incentives for banks to lend to SMEs. The ECB however cannot provide loans directly to SMEs or non-financial firms.

Speaking to CNBC, former ECB Vice President Vitor Constancio said he “doesn’t see a way around this.”

“What the ECB has been doing for quite a number of years is to accept as collateral presented by the banks, pools of their loans to SMEs. This can expanded, but the problem now is not insufficiency of collateral held by the banks,” he said.

He added that if governments provided guarantees to bonds issued by SMEs — like Italy does — the ECB could potentially buy these if certain criteria were met. Although he concedes that such a move would be unlikely and small in size.

One other measure Constancio thinks could be effective is in the regulatory sphere, by having bank supervisors allow “forbearance” in renewing loans to SMEs and by temporarily not classifying them as non-performing loans.

As European investors anticipate another package of measures from the ECB this Thursday, this is the central bank’s chance to lead the way on monetary response and think outside the box. The onus is on the bank to get it right.

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