Quantitative Easing In Europe: The Good, The Bad and The Ugly
Quantitative Easing or QE is a form of monetary policy intervention, whereby central banks use electronically created cash to buy large quantities of sovereign debt. In a way QE could be considered similar to open market operations undertaken by central banks, except on a larger scale. The European Central Bank has been on a drive to spur growth in the Eurozone and prevent a lapse into deflation for a while now. Since lowering interest rates to negative levels has so far proven inadequate, last October it embarked upon an asset purchase program- consisting mainly of covered bonds and asset backed securities. However neither is as effective at shoring up money supply as sovereign debt. To that effect ECB president Mario Draghi has proposed a bond buying programme of €60 billion euros a month, starting March- totalling €1 trillion by 2016.
In recent years several governments including those of Japan, US and the UK have used QE to try to stimulate growth- with varying degrees of success, but QE in Europe is a different animal altogether. For one- in the absence of a central financial authority- QE in the Eurozone would be carried out by the central banks of individual countries on a pro rata basis. Though this is meant to shield countries from bad debt elsewhere in the Eurozone this condition is contradicted by the regulation requiring all income generated, and credit losses to be divided among ECB shareholders according to capital key.
The main objective of QE is to stimulate growth, which it may do in a number of ways. An increase in money supply would lead to downward pressure on prices leading to an increase in demand. It is expected that under these conditions people would buy more, and spend more- stimulating growth. A fall in price levels would also make exports more competitive leading to growth through increases in export incomes and possibly even tourism. From the perspective of the financial markets, increased money supply would lead to a swell in bank reserves which could be used to purchase financial assets and boost asset prices. Lower borrowing costs would also lead to a boost in lending- which would in turn spur demand and growth. Overall it would lead to optimism in the economy which would spin-off into a number of effects.
In terms of the actual effects of QE, the announcement of the programme has generally had a positive effect on the level of optimism in the markets. It sparked a market rally that even the victory of Syriza in Greece was unable to offset, the FTSE Eurofirst 300 index having risen 7% so far this year.
Further the euro has also gained from depreciation, which will help to make Eurozone exports more competitive. It is now down by 19% against the dollar since May 2014, and by 10% against its trading partners’ currencies. Countries like Germany, where export income constitutes 50% of the GDP will benefit significantly. However, this also has the effect of making imports more expensive, and the benefits may take time to trickle down to the economy. Currency depreciation is only a means to pursue growth and not an end in itself.
Since the announcement, Eurozone government debt has been in high demand driving down yields to even negative levels- which will lead to a massive decline in government borrowing costs. Earlier this week- Finland became the first country to pay negative yield on its five year debt. About a third of the Eurozone’s sovereign debt market is now trading at negative yields including Austria, Sweden, and the Netherlands. Even yields for corporate bonds issued by Nestle slipped into negative territory this week. However this may not be such a positive sign given that it shows investors’ unwillingness to abandon safe government and other debt in favour of riskier assets, to the extent that they are ready to accept negative returns in order to ensure the safety of their cash. In this case it would seem that the financial markets do not have much faith in the central bank’s promises to kindle inflation.
Hope may be on the horizon though, as high-risk contingent- convertible (Coco) bonds have enjoyed a depression in yields since the announcement of QE, from 5.86% to 5.48%. This may yet indicate the beginnings of a healthy appetite for risk that may drive growth. Collateral Debt Obligations (CDOs) – the much maligned debt instruments that many blame for the financial crisis have also doubled their trading volumes in the past year.
Given its history with hyperinflation- Germany has remained unconvinced about the effectiveness of QE. It is of the opinion that increasing money supply is an easy solution for underlying problems that can only really be solved by governments increasing competitiveness, and spending within their means. Simply increasing money supply may fuel unsustainable asset bubbles and not bring enough real gains.
One of the main concerns about QE in Europe is that the gains may not be distributed equally among all countries. Since the bond buying will be done on a pro rata basis it is core economies like Germany which will end up getting a lion’s share of the capital rather than peripheral economies which are more urgently in need of help.
Additionally considering the low rates of interest, banks may not react as expected by expanding lending. And even if they do, piling more debt on an already highly debt-ridden European economy may not be a good idea. Debt-GDP ratios in countries including Ireland, Portugal and Spain have already changed by more than 100% since 2007. The coming into power of left-wing anti-austerity party Syriza in Greece has also thrown many calculations off balance.
In spite of all the speculation- it is hard to predict what will really happen if QE is implemented in the Eurozone. But with fears of deflation growing, inaction is no longer an option.
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