January 21st, 2015 | By Nick Sargen
Two-and-a-half years ago, while the euro-zone was in the throes of its worst crisis, Mario Draghi, President of the ECB, appeared to have pulled off a coup, when he asserted that the central bank was committed to do everything in its power to preserve the euro. Market participants interpreted his statement to mean that the ECB was prepared to purchase sovereign debt of countries such as Spain, Italy, Portugal, and Ireland, whose yields had surged to levels that were considered unsustainably high. Soon after, yields on their government bonds began falling, even though the ECB did not make outright purchases, and they continued to fall over the next two years as worries about a break-up of the euro-zone faded.
Last year, a new set of problems surfaced when the euro-zone economy slipped into mild recession and inflation expectations fell well below the ECB's 2% target. In these circumstances, Draghi lobbied for authorization for the ECB to expand its balance sheet considerably via quantitative easing to jump start the economy and lessen the risk of deflation. For a while the central bank limited its purchases to bonds issued by the private sector, but as inflation rates continued to decline and in some instances turned negative, Draghi sought authorization to begin a program of purchasing government bonds. Last week's ruling by the European Court of Justice cleared the way for the ECB to do so. The latest press reports indicate it is expected to announce a program of purchases of euro 50 billion monthly from March of 2015 through the end of 2016, for a total of more than one trillion euros. However, in order to gain the approval of the German government, the ECB reportedly will have to agree that taxpayers are not liable for any losses incurred on other countries' debt.
The challenge Draghi and the ECB face this time is even greater than before, as yields on German bunds and Swiss government bonds are negative out to five years, and yields are negative out to two years for a host of other countries. Thus, many investors are wondering how much lower government bond yields in Europe can go.
Many observers question how effective quantitative easing will be in the euro-zone, considering credit creation occurs mainly through the commercial bank channel rather than through capital markets. In the U.S., by comparison, quantitative easing contributed to significant declines in corporate bond yields both for investment grade and below-investment grade debt, which enabled many companies to obtain financing on lucrative terms. Also, equities represent a smaller portion of household wealth in Europe than in the U.S.; consequently, the wealth effect in Europe from a rising stock market has been less impactful than in the U.S. Ultimately, the ECB is hoping its bond purchasing program will increase bank lending. But it is unclear how this will materialize when banks already are sitting on substantial excess reserves.
In these circumstances, the primary channel through which quantitative easing works is via the currency markets. Indeed, the euro has depreciated by more than 15% against the dollar since last summer, when the ECB began to talk openly about engaging in quantitative easing. In this regard, there are two favorable effects: (i) a cheaper euro enhances the competitiveness of exporters in the euro-zone; and (ii) at the same time, it boosts import prices, which helps to counter deflationary pressures.
On the surface, it appears the ECB has taken a page out of the BOJ's playbook, as quantitative easing by the BOJ has contributed to more than a 40% depreciation of the yen versus the dollar since late 2012. This development, in turn, helped to spark a rally in Japanese equities and it managed to boost prices in Japan after two decades of deflation.
One of the principal lessons from the Japanese experience is that expectations are critical, because deflation is a mindset in which households and businesses come to expect that prices will fall in the future; consequently, they put off spending. In Japan's case, the deflation mindset did not materialize immediately after the stock market and real estate bubble burst in the early 1990s. Rather, it set in later in the decade, when the Japanese economy slipped back into recession after it appeared to be improving. The reason: the Japanese government mistakenly increased excise taxes, which crushed consumer spending, and Japanese banks were still reeling from problem loans following the real estate bust; consequently, the process of credit creation ground to a halt.
In this regard, the timing of the ECB's actions is critical, because headline inflation rates in the euro-zone have turned negative recently amid plummeting oil prices. Normally, lower oil prices would be favorable for the economy, being equivalent to a tax cut for households and businesses. Estimates are that the oil price declines could boost real GDP in the euro-zone by about 0.5% in 2015, which would provide the economy with a much needed lift. However, with headline inflation rates expected to remain negative throughout the first half of this year, it remains to be seen whether economic agents will accelerate spending or delay it.
In such circumstances, it is imperative for European policymakers to have a plan in place to sustain economic growth. This could include relaxing austerity measures in countries such as France and Italy, or granting further debt relief to Greece. There is no indication, however, to indicate the German government is convinced now is the time to relax pressure on countries to embark on structural reforms, which would include reductions of pension benefits or adoption of more flexible labor market arrangements.
Absent any breakthroughs in fiscal policies or structural reforms, the path of least resistance is for the authorities to sanction a further depreciation of the euro. While this has the drawback of having the U.S. shoulder more of the burden of adjustment, the euro is not unduly cheap, trading close to the average level versus the dollar since its launch in 1999. The most likely outcome, in my view, is that it will eventually fall towards parity against the dollar. This will add to pressure for countries with close links to the euro, such as Switzerland. Last week, the Swiss Central bank severed its peg to the euro, as its balance sheet ballooned from currency market interventions to keep the Swiss franc from appreciating against the euro. The result was a 20% appreciation of the Swiss franc, which will hinder the ability of Swiss exporters to compete. Some market participants are wondering which country might be the next to go, with Denmark viewed as a possibility.
The bottom line is that while currency depreciation may help the euro-zone tackle the threat of deflation, it poses challenges for countries whose currencies appreciate against it. However, in the current circumstances, where the U.S. economy is a key engine of global growth, it is the only game in town.