The Quality Of ECB Easing Is Becoming Strained

by: Adam Whitehead


Both the continuation of and the scaling back of QE by the ECB face critical challenges to their acceptance by market observers.

The Spanish and Irish models of banking sector bailout are being presented as a Eurozone panacea.

The threat of deflation is enabling nations to avoid structural reforms and fiscal responsibility.

The ECB’s balance sheet is the real place where fiscal integration is to be found.

Equivocation and inaction is the ECB default posture until the autumn.

Mario Draghi's narrative that ECB policy has benefited the providers and takers of Eurozone liquidity does not stand up to close-scrutiny. This scrutiny is all-the-more revealing currently, as there is a growing sense that the ECB will begin to scale back the size of its quantitative easing program. There are perceived problems with the exit and there are also problems with continued monetary policy expansion. Getting through this period of internal conflict and contradiction will test the ECB's guidance skills and the market's tolerance.

The last report suggested that the next item on the Eurozone agenda would be a taxpayer funded recapitalization of the banking sector, combined with Qualitative Easing from the ECB to enable the banks to support economic growth. Further evidence of this thesis was recently provided by Eurogroup Chief Jeroen Dijsselbloem. In his view, the latest state funded rescue of indebted banks not only serves as a template but also as a precedent and trigger for a wider Eurozone adoption of this standardized procedure. Legislation should therefore follow in his opinion to legalize and formalize this process across the Eurozone.

Further confirmation of the thesis of banking sector recapitalization recently came in the form of the latest Eurozone finance ministers meeting. This meeting specifically addressed the issue of non-performing loans (NPL's). The attendees generally agreed that a mixed private and national government solution should be adopted. This solution envisages the creation of Asset Management Companies (AMC's) that will then buy up non-performing loans from the banks. Allegedly the process applied in Spain and Ireland should serve as the model to be applied. Under this model the AMC's bought up NPL's at 50% of their nominal (NOT market) value. The taxpayers of Spain and Ireland were then on the hook for the difference between the value paid and the real market value of the NPL's; in what was basically a soft taxpayer bailout.

Evidently there is general unhappiness with the way that Italy has recently applied a full state bailout of its banks and got away with it, so the Spanish and Irish model is being promoted to make the future process look less like state aid for the banking sector. Until the rules have been made and rigorously applied however, one can assume that banking union and even deeper fiscal union will be put on hold.

Lurking in the background and providing an ominous global setting are the ongoing Basel III deliberations on bank capital adequacy. With no global agreement upon what the standards for capital adequacy and what its measurement should be, it will be very difficult to make progress on the Eurozone's specific banking issues. Indeed, Eurozone nations could push back against Basel III in order to buy themselves more wriggle room at the EU level. Recognizing that this clock is ticking, ECB Governing Council member Francois Villeroy de Galhau tried to nudge the Basel III discussions towards some kind of conclusion this Autumn. This timing is confluent with the timeline that the EU is hoping to use to resolve its own internal banking issues.

(Source: Bloomberg)

The situation in the banking sector is part of a much larger problem facing the Eurozone and the ECB. BofA Merrill estimates that approximately 10% of the largest listed companies in the Eurozone are "Zombies". It defines "Zombies" as non-financial companies in the Euro Stoxx 600 with interest-coverage ratios -- earnings relative to interest expenses -- at 1 or less. The thesis goes that said "Zombies" are vulnerable to rising interest rates and reduction in QE. It should be born in mind that this figures stood at 6% of listed Eurozone companies prior to the Credit Crunch. Evidently QE has enabled these companies to subsist and to multiply in size and significance to become a systemic risk that has a strong whiff of moral hazard about it. Mario Draghi and his policies have created this monster. The banks have enabled this monster by passing on QE and its terms and conditions to the "Zombies". The banks have then become "Zombies" themselves as their NPL portfolios have grown and festered.

The Bank for International Settlements (BIS) recently warned of the risk of asset bubbles unless QE is scaled back. Last month, it calculated that businesses more than 10 years old whose earnings don't cover interest expenses represent almost 10.5% of publicly listed companies across 13 advanced economies, compared with less than 6% pre-Credit Crunch. Clearly the BIS sees the global moral hazard that QE has enabled and would like the central bank creators of this problem to address it. The real issue is that said central banks have just decided that QE is now an accepted monetary policy tool, rather than an emergency tool as it was first envisaged. QE is here to stay and the risks that it brings are multiplying as a consequence. The global economy has also decelerated, so the central banks are even more keen to keep QE in place.

After the BIS had wagged its finger, the IMF joined the chorus of criticism, specifically signaling out Italy as the poster-child of the moral hazard unintended outcome of combined QE and lack of structural reform. In a terse lecturing statement, the IMF admonished that "Banks' non-performing loan reduction and restructuring strategies should be ambitious, and credible, aided by supervisory assessments."

It is therefore no wonder that the ECB has lectured policy makers about structural reforms. Policy makers have called the ECB's bluff however, because they understand that Mario Draghi will never put the Eurozone at further risk of breaking up. By embarking on Qualitative Easing for the banking system, Draghi is now setting a precedent (and a bid!) for the whole Eurozone spread-risk asset markets. The Eurozone will be saved, but at the expense of wasted economic resources. The health and vigor of the Eurozone to compete globally has been weakened; and the whole economic superstructure is underpinned by a huge subsidy of wasted financial resources from the ECB's balance sheet.

In a direct rebuke to policy makers and the ECB, the Bundesbank recently published its findings on the impact of monetary policy throughout the Eurozone. The Bundesbank found that the ECB's actions have saved the German government 250 Billion Euros over the last decade. It also found that the savings to national governments in the Eurozone have been disproportionately higher for the extremely indebted nations such as Greece and Spain. The report clearly shows the fiduciary incentives that the ECB has provided to sovereign borrowers not to do anything to reform their economies. Leverage nations have been rewarded for and incentivized to scale up their borrowing from the ECB.

The last report also observed the smoke and mirrors going on at the EU level in order to enable the state bailouts of the banks without breaking the taboo of the Stability Pact. Italy was noted as the major transgressor who is setting the precedent and forcing the rules to be bent. Having figured out that the resistance offered by other EU members is token and without any real menace, Prime Ministerial hopeful Matteo Renzi pushed his and his country's luck a little further. Renzi demands that Italy should be allowed to maintain a 2.9% of GDP deficit for five years, so that it can allegedly boost fiscal spending by a minimum of €30bn a year. Under current rules, the Italian budget must aim for a 2.1% GDP deficit in 2017 and 1.2% in 2018. Renzi intends this "big break" as he calls it to be central platform of his campaign to return to leadership of the country and then to deliver his much advertised structural economic reforms. As behavioral economists note, special dispensations become accepted and understood to be entitlements by those who benefit from them. There is therefore no chance that Italy will reform its behavior. More worryingly said behavior is being adopted in varying degrees by all other nations in the Eurozone except Germany.

(Source: Bloomberg)

Objectively speaking, one can see where Renzi is coming from. The poverty level in Italy has tripled over the last decade. It is no wonder that Italians have been attracted to the Populist

Orators, who have shown them a way to inflate their way out of trouble and return to the dolce vita days of the Lira and competitive devaluations. Renzi is offering an alternative solution, by which Italians reform themselves back to competitiveness. His "big break" solution however has a strong element of the inflationist tendencies of old. Given that deflation is an alleged Eurozone threat, his solution may not be as strongly rejected by the EU as perhaps the Germans would like. If Italy will pay a risk premium for its privileges then it may be allowed some fiscal wiggle room. The question now becomes what level of yield premium it will pay and then how the ECB will manage this yield spread through its balance sheet operations to ensure that the Italians play fair.

Initially, Renzi's demand was rejected by both EU Commissioner Pierre Moscovici and Eurogroup chief Jeroen Dijsselbloem. After these initial hollow rejections, EU Vice President Valdis Dombrovskis offered a compromise, in which Italy will be given flexibility as long as it can come up with something on paper that commits to reduce the deficit to a level at which it can be serviced through interest payments. Since the ECB has no intention of letting borrowing costs rise to levels that would make this impossible, it shouldn't be too difficult for Italy to rig a spreadsheet that meets the EU's new requirements. To all intents and purposes therefore the Stability Pact is meaningless and it's a free for all across the Eurozone.

Whilst the fiscal situation is degenerating, into this free for all of rule-bending, it is amusing to watch Angela Merkel and Emmanuel Macron pretending to bring some semblance of order and deeper integration to things. The more things slide, the more they pretend that things are coming together. This latest act of mutual absurdity came with Chancellor Merkel opining that she has always been a bit of a one for deeper fiscal integration; and that she is happy to talk about the creation of a Eurozone Finance Minister and common budget. Her enthusiasm only reaches as far as being open to this in principle. The devil is in the detail and thus far there is little of that on the table. Merkel has nothing to lose and neither do German taxpayers from talking in generalities.

European Stability Mechanism managing director Klaus Regeling began the process of nudging Eurozone members towards the specific devil in the details of fiscal integration. His baby steps begin with the creation of what he calls a "rainy day fund". This he envisages as roughly equivalent 1-2 percent of the Eurozone's gross domestic product (GDP). That would be roughly 100 to 200 billion Euros ($115 billion to $229 billion) based on present valuations. This pales into insignificance when compared to the multi-trillion Euro ECB balance sheet, which is the true "rainy day fund". The creation of such a fund should therefore be easy to achieve, as should be the rules governing its deployment. One should not be fooled into thinking that the fund will have any ability to stop a real a crisis however. Its significance is politically symbolic and comes with the overt signal that the IMF will be expelled from meddling in Eurozone affairs going forward. For this reason, it will be a landmark.

Ever since Mario Draghi recently injected the prospect of the end of QE into the capital market discounting mechanism, some of his colleagues have been attempting to frame this as a reduction rather than an end of the monetary stimulus per se. ECB Governing Council member Ilmars Rimsevics kicked off the latest phase of Draghi damage mitigation. Based on his assessment of inflation conditions, he could see QE purchases continuing for "a couple of years".

On the eve of the latest Governing Council meeting council member Francois Villeroy de Galhau framed the upcoming deliberations with an assessment of where the mission to stimulate inflation is currently at. In his opinion, the ECB has made progress steering inflation towards its two percent target but loose monetary policy is still required. The meeting was thus framed as a discussion about by how much to throttle back QE but not about how to end it. The meeting then left policy unchanged along with a guidance commitment to expand monetary policy if inflationary risks persist. Mario Draghi stated that discussion about the scaling back of monetary policy easing will occur in the autumn; but gave no indication that this will be at the September meeting. With a vague commitment to talk about reducing the size of QE and an unchanged policy stance, the ECB does not appear to be in any hurry. In fact it was evident that Draghi was at pains to scale back market expectations for a reduction of QE, which had gathered strength since developed central banks made noises to conform with the Bank of International Settlement's latest edict to deflate asset bubbles.

Following the Governing Council decision, the ECB's survey of inflation expectations taken from professional forecasters showed continued falling expectations. Whilst this endorses the latest Governing Council decision, it is also possible that forecasters have been influenced by the continued message on undershooting inflation put out by the ECB.

Speaking for the Executive Board of the ECB, Yves Mersch reaffirmed its position in support of the Governing Council's continued application of expanded monetary policy. In the recent past, the Executive Board has signaled its unease with continued monetary policy expansion. Now it would seem that the Executive Board is in full support of continued monetary policy expansion. The justification for this support for the Governing Council's position is the continued failure to reach its inflation target. As Mersch opined: "Reflationary forces are at play. Price pressures in the early stages of the pricing chain remain strong but have still not transmitted to the later stages."

The new line adopted by the Executive Board was then endorsed by the IMF. In the continued absence of stronger inflation, the IMF argues that it would be premature to scale back the current monetary stimulus.

The role of Governing Council member Ewald Nowotny is becoming more clearly defined. It would appear that he is shadowing Mario Draghi's comments by mildly contradicting them. This has the effect of smoothing the market reactions to Draghi's initial comments. When Draghi caused a panic about tightening, Nowotny contradicted by saying that inflation readings give no cause for imminent scaling back of QE. On the recent guidance, Nowotny re-balanced Draghi's softer comments by saying that: "I (Nowotny) consider it wise to gently step off the gas pedal." The Draghi-Nowotny dynamic illustrates the status quo perfectly. Equivocation followed by inaction! As the political and economic situation deteriorates in America and over the Brexit, this status quo will stay in place for longer.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.