Is a Credit Crunch Imminent in the Euro Zone?
Posted by: Linda Yueh on January 13, 2012
Markets will be digesting yesterday’s news from the European Central Bank, which offered a great deal of detail on its unprecedented three-year loans to banks and the outlook for the euro zone.
ECB President Mario Draghi said that the record 489 billion euros of three-year loans to euro-zone banks has prevented a credit contraction from worsening. The cash has, after all, flowed into the real economy, even as deposits of cash at the ECB reached a record high of 489.9 billion euros overnight today. Amidst criticism that the money loaned out to banks was just being hoarded at the ECB, Draghi revealed that the banks that borrowed the cash are different from the ones that made the deposits.
“We really see evidence, signs that this money doesn’t just stay in the deposit facility… We have other signs that this money is actually flowing in the economy… by and large, the banks that have borrowed the money from the ECB are not the same as the ones that are depositing the money at the ECB.”
The loans reduced liquidity risk for the banks and gave time to those that needed to sort out their balance sheets. And, Draghi said it was “comforting to see some opening in unsecured bank-bond markets,” referring to the concern that smaller banks had been shut out of markets and the larger ones had been issuing record amounts of more costly covered bonds to raise funding. Nevertheless, he expects demand to be high when the ECB offers three-year loans again at the end of February.
Still, the risk of a credit crunch has implications for the real economy. To counter this, and in view of what Draghi calls “substantial downside risks” to growth and “balanced risks” to inflation, monetary policy could be loosened. This is the why the 1% interest rate may not be a floor. In fact, Citigroup, JPMorgan and Morgan Stanley expect rates to fall to a new record low of 0.5% by mid-year, though the median forecast is for rates to stay at 1% through mid-2013.
The alternative to rate cuts would be to undertake quantitative easing like the Fed and Bank of England. Draghi avoided answering whether former ECB Council Member Lorenzo Bini-Smaghi was right in saying that QE was possible should there be deflation and that QE could be “tailor-made” for the euro zone. So, for now, that leaves further interest-rate cuts.
One obstacle in this course is that the euro zone, unlike three years ago, faces substantial deleveraging. The International Monetary Fund estimates that total private and public debt was 440 percent of GDP in the euro area in 2011, higher than the 376 percent of GDP in the U.S. Deleveraging could lead to deflation—this is what led the Fed to do QE once rates couldn’t be lowered further than 0 percent. The euro zone experienced deflation in 2009, when prices fell as much as 0.7 percent. If this happens again with recession looming and rates close to zero, then a tailor-made QE programme may not sound like such a bad idea.
(Corrects to say deflation in sixth paragraph.)
Photograph by Daniel Roland/AFP/Getty Images
