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Draghi’s $1.4 Trillion Shot: Silver Bullet or Misfire?

By Jana Randow and Alessandro Speciale
July 07, 2014 7:03 AM EDT 24 Comments
Mario Draghi, president of the European Central Bank.
Photographer: Jasper Juinen/Bloomberg
Mario Draghi, president of the European Central Bank.

Mario Draghi’s plan to end the euro area’s lending drought risks missing the target.

While the European Central Bank president says a program to hand as much as 1 trillion euros ($1.4 trillion) to banks has built-in incentives to spur lending to the real economy, analysts from Barclays Plc to Commerzbank AG have doubts on how well it will work. In fact, the measure allows banks to borrow cheaply from the ECB even without increasing credit supply.

Draghi has identified weak lending as an obstacle to the euro area’s recovery and is committed to reversing a slump that has eroded more than 600 billion euros in loans to companies and households since 2009. The risk is that if the latest plan fails, the currency bloc slips closer to deflation and to the need for more radical action such as quantitative easing.

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“It’s not the silver bullet,” said Philippe Gudin, chief European economist at Barclays in Paris. “Every incentive for banks to lend is a good thing, but I wouldn’t say I’m reassured that credit will pick up.”

The ECB’s latest plan differs from its previous liquidity measures in the way it tries to nudge banks into lending more to the real economy. In contrast, three-year loans issued in late 2011 and early 2012 were used largely to buy higher-yielding government bonds, a practice known as the carry trade.

Attractive Option

Targeted longer-term refinancing operations will offer banks an initial total of as much as 400 billion euros this year that they can hold until 2016 with no strings attached. They can keep it another two years if they meet specific new lending targets set by the ECB, and they can borrow more funds starting in March if they exceed those thresholds. At his monthly press conference on July 3, Draghi said the total take-up could be 1 trillion euros.

Europe's Banking Union

“If this sounds a little complicated, I think you’re right,” he told reporters in Frankfurt. “But I’m confident that the banks will quickly understand that even though it’s complicated, it’s also quite attractive.”

Still, to keep the initial batch of funding for the full term, banks aren’t required to expand their loan books. They are only obliged to boost credit if they wish to borrow more cash starting next year, when the ECB will provide as much as 3 euros for every 1 euro of net new lending.

Bank Review

That’s a hindrance while the euro area’s subdued recovery keeps credit demand by companies weak, according to Marco Valli, chief euro-area economist at UniCredit SpA in Milan.

“It is unlikely that companies that had no intention of investing will start to do so now,” he said. “It isn’t clear that banks in peripheral countries where private sector debt needs to be reduced further will be capable of returning to flat or positive net lending in about a year. This could restrain the impact of this facility.”

The attitude of banks toward the TLTROs may become clearer after the ECB finishes its health check of their balance sheets. The asset quality review and stress tests are designed to strengthen the banking system by identifying any capital shortfalls before the ECB becomes the euro-area bank supervisor in November.

The final take-up of the TLTROs “could be significantly higher than the initial allowance of 400 billion euros,” said Christian Schulz, senior economist at Berenberg Bank in London. “That could provide a significant boost to lending after the completion of the asset quality review.”

Deflation Threat

The TLTRO program is the newest attempt by policy makers to strengthen a fragile recovery and avert the threat of deflation. Consumer prices rose an annual 0.5 percent last month, compared with the ECB’s goal of just under 2 percent.

Officials are also waiting to see the broader impact of the stimulus they announced in June, which included an unprecedented negative deposit rate and a commitment to providing unlimited short-term liquidity for at least another two years.

Executive Board member Benoit Coeure said on BFM Radio today that it will take time to evaluate the effect of the measures. Governing Council member Ewald Nowotny said in Vienna that the package has already had a “considerable impact” and markets have “understood” it.

The euro has declined 0.5 percent against the dollar since the June 5 meeting and traded at $1.3598 at 12:58 p.m. Frankfurt time. The three-month Euribor declined to 0.203 percent from 0.292 percent over the same period.

“They have too high expectations” of the TLTRO, said Jan Von Gerich, a fixed-income analyst at Nordea Bank AB in Helsinki. “The program will support the euro-area economy but it falls short of what would be required to tackle low inflation. There’s scope for more aggressive measures.”

Asset Purchases

That could eventually mean broad-based asset purchases, an option that Draghi has said is available should the outlook for inflation worsen. The ECB has already said it is intensifying preparations for a smaller program that could see it buy asset-backed securities.

For banks, the temptation at least until the euro-area revival is entrenched is to continue their practice of using funds borrowed cheaply from the ECB to invest in sovereign debt. While that prevents the money reaching the real economy directly, the Dutch central bank says it still has the benefit of reducing broad borrowing costs.

Carry Trade

“Banks may increase lending but can also use the funding for purchases of other assets, such as corporate bonds, commercial paper and government paper, which will help bring down rates across the board,” the bank said on its website last month.

Debt markets are reflecting the possibility of more carry trades. Spanish two-year yields and Irish 10-year yields dropped to records last week. German one-year rates fell below zero for the first time since June 2013.

“The ECB is helping finance ministers in the periphery as much as it is helping borrowers, maybe even more,” said Joerg Kraemer, chief economist at Commerzbank in Frankfurt. “The TLTROs are much less targeted than the name suggests. Of course, you could use the funds to boost credit supply, but you can also use them to buy government bonds.”

To contact the reporters on this story: Jana Randow in Frankfurt at jrandow@bloomberg.net; Alessandro Speciale in Frankfurt at aspeciale@bloomberg.net

To contact the editors responsible for this story: Craig Stirling at cstirling1@bloomberg.net Paul Gordon, Zoe Schneeweiss

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