News analysis

ECB stimulus drive could backfire

FRANKFURT • One hopes at the very least, European Central Bank (ECB) president Mario Draghi is able to buy kitchen sinks in bulk at a discount. Because on Thursday, for the umpteenth time in his five years in that job, he has thrown his and everything else at Europe's continuing economic malaise.

This time, the ECB managed a quadruple whammy: cutting its short-term interest rates to even further below zero; pumping an additional €20 billion (S$30.5 billion) a month into the euro zone economy through quantitative easing (QE), expanding the QE programme to include corporate bonds to make more credit available to businesses; and encouraging more borrowing by creating a new bank-lending programme.

This would seem, on its face, to be a really aggressive intervention to try to jolt Europe out of its deflationary muddle. Indeed, when it was announced, the euro fell 1.1 per cent against the US dollar, bond yields fell and European stocks rose, all suggesting the financial types saw it that way.

But less than 90 minutes later, as Mr Draghi began addressing the media, those market shifts reversed. Euro reversed its decline, rallying as much as 2 per cent after Mr Draghi said he did not see any need to cut interest rates further. The remark also led to European shares plunging 4 per cent from the highs of the session on damped enthusiasm (They rose back yesterday, led by bank stocks and a recovery in metal and oil prices boosting commodities stocks).

For years, new rounds of QE and other moves have been the response to periods of market tumult and economic weakness. It had greatest impact by pumping up prices of stocks and other financial assets. That made consumers wealthier and lowered the cost of capital for businesses, helping to restore confidence and encourage economic activity.

Now markets fear the central banks just have nothing left to combat global deflationary forces that seem more powerful with every tick down in the price of oil. Not so, according to Mr Draghi. "We have shown we are not short of ammunition," he said.

But, it is not clear that asset prices are as powerful a channel for central bank activism to stimulate the economy as it was in earlier years when they were undervalued. It is also not clear if further large increases in financial markets' values would provide anything other than an unwelcome bubble.

ECB's decision to buy corporate bonds will be a boon for investors but may have a muted impact on inflation, given the small size of that market and its tenuous link to the broader economy. Mr Draghi said the move would ease financing conditions in the real economy, presumably by lowering yields on corporate bonds - effectively making it cheaper for companies to borrow money on the market.

But, this would be a small portion of the ECB's monthly purchases, which were increased to €80 billion on Thursday. The market for such notes is small and is mainly made up of large corporations that have enjoyed low financing costs for years.

"Is it enough to boost inflation? I'm not so sure," said Mr Philippe Gudin, an economist at Barclays. "It's not a silver bullet. Inflation is still low because there are external factors and the recovery is modest."

ECB's new lending offer, to pay banks that borrow money from it, would mean that banks qualify for billions of euros of initially free loans and would get paid up to 0.4 per cent of what they borrow on condition they lend more to firms or consumers.

If it works, the plan will make it easier and cheaper for borrowers across the 19-member euro zone, although some critics pointed to the failure of earlier similar ECB schemes and the reluctance of banks to lend as the economy struggles.

"They are throwing money at the banks but it's not a game changer," ING economist Carsten Brzeski said. "The ECB cannot force the private sector to go to the bank to get money. Loans are already cheap. Have we seen a take-up in credit growth? No."

Finally, negative rates, where ECB will charge banks to park money with them, may encourage more lending and economic activity. But if they go deeper into negative territory, they could cause people to withdraw money from banks and throw the business models of banks into chaos. In other words, Mr Draghi may still be able to buy a few more kitchen sinks to throw at Europe's economic problems. But each one may get more expensive and a lot harder to throw.


A version of this article appeared in the print edition of The Straits Times on March 12, 2016, with the headline 'ECB stimulus drive could backfire'. Print Edition | Subscribe