A year ago today, Mario Draghi pledged to save the euro and unblock credit to companies. His job is only half done.
Bond yields down from panic levels across the region are proof of the European Central Bank president’s success in promising “whatever it takes” to preserve the common currency. Even after he crafted an unprecedented plan to buy the bonds of distressed nations, companies in countries such as Spain are still struggling to obtain funding, suggesting his aim of ending financial fragmentation remains elusive.
“The bond-purchase program was designed to fix the fact that low interest rates didn’t have an impact on credit supply to companies and households in the periphery,” said Ralf Preusser, head of European rates research at Bank of America Merrill Lynch in London. “Its success shouldn’t be measured by whether bond yields have fallen but whether companies have an easier time to access credit at better rates. There, the answer is clearly no.”
While Draghi proved on July 26 last year that the central bank has the power to change the course of the region’s crisis at a stroke, record-low interest rates haven’t reached those members of the 17-nation euro region most in need. That leaves investors and entrepreneurs seeking another policy lightning bolt from the central bank that may not come.
The ECB reduced its benchmark interest rate to 0.5 percent in May. The same month, Spain’s 10-year yield fell to 3.94 percent, the lowest since 2010 and down from a euro-era record of 7.75 percent reached the day before Draghi’s July speech. Spain’s borrowing cost is at 4.66 percent today, down from an average this year of about 4.8 percent.
Draghi told investors and business leaders in his London speech that the “key strategy point” for saving the euro would be to repair financial fragmentation. When he announced an unlimited bond-purchase program dubbed Outright Monetary Transactions six weeks later, he said that “we should therefore see some improvement on the credit front.”
That hasn’t happened. Euro-area banks have continued to tighten credit standards and reduce lending, ECB data shows. Loans to the private sector have contracted for 14 months and fell by the most on record in June.
Average interest rates on new loans to businesses in Spain rose to 3.89 percent in May 2013 from 3.68 percent in June 2012, ECB data show. Rates fell 12 basis points in Belgium, 16 basis points in Slovenia and 1 basis point in Italy. The average decline in the euro area was 29 basis points, helped by a drop of 61 basis points in Germany, Europe’s largest economy, which is seen as a haven amid the crisis.
The euro-area economy shrank in the six quarters through March, the longest recession since the single currency started in 1999. The ECB forecasts gross domestic product will contract 0.6 percent this year, after declining the same amount in 2012.
The currency bloc is showing some signs that it may be emerging from its slump and that credit access may be improving. Manufacturing unexpectedly expanded in July for the first time in two years, according to a purchasing managers’ index from London-based Markit Economics. Banks loosened credit standards for loans to consumers in the second quarter for the first time since the end of 2007, the ECB’s Bank Lending Survey showed.
Economic and market strains in nations from Portugal to Cyprus haven’t pushed governments into applying for the OMT. The still-untapped program is “probably the most successful” policy measure of recent times, Draghi said on June 6.
With inflation slower than 2 percent, Draghi still has room to bolster economic sentiment. Options include another cut in the benchmark rate, charging banks for depositing money at the ECB, linking the bank’s guidance on future policy to economic indicators or time horizons, or introducing more long-term loans to banks.
“The ECB probably hopes that they don’t need to do anything,” said Mark Wall, chief euro-area economist at Deutsche Bank AG in London. “The ECB is increasingly relying on words but the risk is that the more you rely on rhetoric policy, the bigger the chances that the market will call your bluff.”
The central bank has argued that financial fragmentation has eased since the OMT’s announcement, even as bank lending continues to decline. In an April presentation in Brussels, ECB Vice President Vitor Constancio cited the shrinking imbalances in the euro-area’s payments system, known as Target2, as one indicator.
Germany’s Target2 surplus has fallen from 729 billion euros ($963 billion) in June 2012 to 575 billion euros last month. Spain’s Target2 deficit has dropped to 284 billion euros from 372 billion.
“It is hard to avoid the conclusion that the OMT has proved to be of considerable benefit over the past year,” said Huw Pill, chief European economist at Goldman Sachs Group Inc. in London. “Existential tail risks have diminished dramatically. And, while credit markets remain painfully segmented, the threat of a systemic collapse in the European financial sector has receded.”
Furthermore, Draghi’s defense is that monetary policy can’t go it alone.
“It is essential that the fragmentation of euro-area credit markets continues to decline further and that the resilience of banks is strengthened where needed,” he said in his monthly press conference on July 4. “Further decisive steps for establishing a banking union will help to accomplish this objective.”
Political progress on establishing that union isn’t going as fast as the ECB would like. Months of wrangling over who will pay when banks fail and the fact that European Union lawmakers won’t vote on the legislation before September mean the ECB can’t start its task of supervising financial institutions until late 2014, at least six months behind the initial target of March.
That also delays an ECB review of banks’ balance sheets and the subsequent stress tests that are supposed to show the health of financial institutions, so helping to kickstart lending.
Declining credit puts “serious question marks over the strength of the nascent recovery across the region,” said Martin van Vliet, senior euro-area economist at ING Groep NV in Amsterdam. “It is difficult to envisage a sustainable euro-zone economic recovery without a pick-up in bank lending.”
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