“The ECB is administering an even higher dose of the same medicine that didn’t work in the past” – Hans Michelbach, MP in German conservative CSU party

ECB President Mario Draghi announced last week a 10 bps cut to the deposit rate – reducing it to its lowest level of -0.5% – and the relaunch of quantitative easing (QE).   

Although Draghi was rather optimistic at the beginning of 2019, announcing the conclusion of the 2 year-long QE and thus the start of ECB’s balance sheet normalisation without any expected change of the interest rate, his tone changed in the March ECB meeting. He then announced a new round of long-term debt to European banks (TLTRO-III) which will start this month and end in March 2021. A QE programme will restart this November, with the ECB buying EUR 20 billion worth of assets (sovereign bonds mainly) every month, until the zone’s inflation hits the 2% target.

The quote above depicts the harsh opposition and criticism Draghi’s decision received, as critics fear an indefinite prolongation of the QE (commonly referred to as “Draghinomics”) much like the case of Japan, which is in its 15th year of QE and in its 6th year of “Abenomics” QE. Although the theory of QE is highly debated among economists, in this article I will try to evaluate the past performance of Draghinomics, see what lessons can be extracted from Japan, and lastly consider the implications of this new stimulus package on currencies and credit markets.

Past performance

QE aims to maintain inflation (i.e. consumption) at a stable rate and to avert the inversion of the yield curve, in periods of economic crisis.

Chart 1 shows that the first use of QE by the ECB in 2015 did avert deflation, and contributed to a GDP growth of 2.1% that year. The introduction of Abenomics in 2013 was also effective, as inflation overshot the 2% target with a 2% output growth. However, the chart shows that both central banks’ QE did not manage to keep the economies at their common inflation target afterwards, with occasional periods of deflation happening despite the QE programmes in place.

Chart 1


Chart 2 below shows the spreads between short-term and long-term sovereign yields of Germany and Japan. The higher the spread, the higher the long-term yield is relative to the short-term one. Taking Germany as a proxy for the Eurozone’s sovereign yields, the chart shows little correlation between QE and the spreads of Germany’s bunds, to the contrary of Japan’s case.

Chart 2

Source: Bloomberg

Lessons

Lesson 1- Complications of asset-purchasing

A study made last year by Sayuri Shirai, a Keio University professor who was a board member at the Bank of Japan (BoJ) delved deep into the country’s QE programme consisting of buying foreign stock and ETFs (BoJ has now an asset-to-GDP ratio alarmingly over 100%). It pinpoints how the programme overvalued small-cap stocks, and how that it did not help the Nikkei 225 index regain its values pre-1991 asset bubble burst. This, coupled with how BoJ is among the largest shareholder in 40% of listed companies scared investors away. Her study concluded that the Bank should re-consider its inflation target. Future ECB president Lagarde should perhaps review ECB’s inflation target too and carefully consider what assets ECB is buying as part of its QE programme in order to avoid the flight of investors and a complicated balance sheet normalisation in the future.

Lesson 2- Reliance on exports and ageing populations

Several studies showed that Japan never regained its pre-crisis highs due to the decreasing productivity of its ageing population and its reliance on exports. These macro factors are omnipresent in the Eurozone as well and are made worse with Trump’s protectionism policies / wars in place. These two issues should be addressed by European governments to ensure the possibility of their economic growth and enable the effectiveness of QE.

Lesson 3- Synergy between monetary & fiscal policy

Contrary to Japan, the ECB cannot enforce fiscal stimulus policies across the Eurozone. When Japanese Prime Minister Abe took power in 2013, he put in place fiscal austerity policies to try to decrease the budget deficit. Some criticise this move by saying it contributed to a downturn in GDP growth, while others say that it helped reduce unemployment rates. European governments should agree on a trade-off between a wider budget deficit and stirring economic growth. Therefore, a challenge Lagarde should consider is whether to continue the QE programme, or to replace it with other innovative monetary polices such as helicopter money, and/or to create incentives for each country to put in place adequate fiscal policies.

Implications

Even though the euro bounced back after it fell following Draghi’s announcement and bonds rallied, with the current gloomy political and economic outlook of the Eurozone, investors will most likely revert to the dollar leaving the euro subdued. It is worth noting that when the first QE started in 2015, the euro had an upward trend until the end of 2016.

With a new TLTRO in place, banks will face increased competition in the lending area, which will translate into a lower margin to borrowers deemed safe. European credit funds will likely continue their development, as their clientele will expand to include borrowers the banks’ balance sheets cannot afford, which includes new funds asking for asset-backed and bespoke facilities.

Author: Dana Kambris