Month: September 2019

How successful has the “Fourth Phase” of ECB monetary policy been?

An important goal of the current “Fourth Phase” of ECB monetary policy is “to ensure that businesses and people should be able to borrow more and spend less to repay their debts”.

The ECB has achieved partial success here with private sector credit in the Euro Area now growing at the fastest rate in the current credit cycle (in nominal terms) thanks in part to lower borrowing costs.

Following the standard transmission mechanism of monetary policy, the cut in official rates has fed through into money market interest rates (and expectations) and into the cost of borrowing for corporates (NFCs) and households (HHs) in the Euro Area. Since the end of May 2014, the MRR has fallen by 25bp, 3m Euribor by 69bp, and the composite cost of borrowing for NFCs and HHs by 123bp and 134bp respectively. This has represented an important shift in the balance of power from lenders/creditors to borrowers/debtors (see “Power to the Borrowers” – who are the winners from QE?). Private sector credit (PSC) stopped falling in March 2015 and is currently growing at 3.6%, the fastest nominal rate of growth in the current credit cycle.

The obvious caveats to this success story are the facts that current growth is (1) muted in relation to past cycles, and (2) limited geographically. Progress in emerging from the Euro Area’s debt overhang remains slow and incomplete. Economic cycles are shallower, money supply is subdued and credit demand is relatively week. These trends are entirely consistent with the “Balance Sheet Recession” concept and trends seen previously in Japan.

The current growth rate in PSC of 3.6% is well below the average of 8.3% in the decade between June 1999 and June 2009 and the peak growth of 11.7% reached in September 2016. Current growth is also dominated by Germany and France rather than broad based across the Euro Area. HH credit is growing 2.9% YoY (outstanding stock basis) of which France contributes 1.3%, Germany 1.2% and the Benelux 0.3%. Similarly, NFC credit is growing 3.1% YoY with Germany contributing 1.9% and France 1.6% while Spain, Italy, and Greece, Ireland and Portugal (GIP) all making negative contributions.

COCO versus FIRE – contrasting productive and unproductive credit

A less obvious, but more important, caveat is that the majority of Euro Area credit is now directed into “unproductive” FIRE-based credit rather than more “productive” COCO-based credit.

In the broadest sense, lending can be spilt into two distinct types: lending to support productive enterprise; and lending to finance the sale and purchase of existing assets. The former includes lending to NFCs and HH consumer credit, referred collectively here as “COCO” credit (COrporate and COnsumer). The latter includes loans to non-bank financial institutions (NBFIs) and HH mortgage or real estate debt, referred to collectively as “FIRE” credit (FInancials and Real Estate). Dirk Bezemer (www.privatedebtproject.org) neatly distinguishes between the productivity of these different forms of lending:

• COCO-based lending typically supports production and income formation

• CO: loans to NFCs are used to finance production which leads to sales revenues, wages paid, profits realised and economic expansion. Bezemer notes that these loans are used to realise future cash revenues from sales that land on the balance sheet of the borrower who can then repay the loan or safely roll it over. The key point here is that an increase in NFC debt will increase debt in the economy but it will also increase the income required to finance it

• CO: consumer debt also supports productive enterprises since it drives demand for goods and services, hence helping NFCs to generate sales, profits and wages. It differs from NFC debt to the extent that HH take on an additional liability since the debt does not generate income. Hence the consumer debt is also positive but has a slightly higher risk to stability

• FIRE-based lending typically supports capital gains through higher asset prices

• FI: loans to NBFIs (eg, pension funds, insurance companies) are used primarily to finance transactions in financial assets rather than to produce, sell or buy “real” output. This credit may lead to an increase in the price of financial assets but does not lead (directly) to income generated in the real economy

• RE: mortgage or real estate lending is used to finance transactions in pre-existing assets rather than transactions in goods and services. Such lending typically generates asset gains as opposed to income (at least directly)

Lending in any economy will involve a balance between these different forms, but the key point is that a shift from COCO-based lending to FIRE-based lending reflects different borrower motivations and different levels of risks to financial stability.

Over the past twenty years, FIRE-based lending has increased from 48% of total Euro Area loans to 55% as at June 2019. The current level represents a historic high. At the individual country level, the ECB has provided a breakdown on MFI balance sheets since December 2002. At the starting point of this data, COCO-based lending exceeded or equalled FIRE-based lending in six out of ten large Euro Area economies: Austria (73%:27%); Greece (73%: 48%); Italy (58%:42%); France (58%:42%); Spain (56%:44%) and Portugal (50%:50%).

As of June 2019, only three of the countries in this sample have COCO-based lending above or equal to FIRE-based lending: Austria and Greece (54%:46%) and Italy (50%:50%).

To what extent is QE fuelling the fire?

The shift towards these forms of credit pre-dates the introduction of QE in the Euro Area. As the data above suggests, this is part of a longer term trend. Indeed, at both the Euro Area level and the country level, the split between COCO-based and FIRE-based lending is broadly unchanged since both May 2014 and March 2015.

The shift is more noticeable since the end of the Global Financial Crisis however and may also reflect that NFC debt levels (expressed as a percentage of GDP) remain high and above the threshold levels that the BIS considers detrimental to future growth.

Nevertheless, the hidden risk in QE is that the ECB is “Fuelling the FIRE” with potentially negative implications for leverage, growth, financial stability and income inequality in the Euro Area.  

As noted above, while COCO-based lending increases absolute debt levels, is also increases incomes (albeit with a lag), hence overall debt levels need not rise as a consequence. In contrast, FIRE-based lending increases debt and may increase asset prices but does not increase the purchasing power of the economy as a whole. Hence, it is likely to result in high levels of leverage.

Similarly, COCO-based lending supports economic growth both by increasing the value-add from final goods and services (“output”) and an increase in profits and wages (“income”). In contrast, FIRE-based lending typically only affects GDP growth indirectly.

From a stability perspective, the returns from FIRE-based lending (investment returns, commercial and HH property prices etc) are typically more volatile that returns from COCO-based lending and may affect the solvency of lenders and borrowers.

Finally, the return from FIRE-based lending are typically concentrated in higher-income segments of the populations, with any subsequent wealth-effects increasing income inequality.

Please note that the summary comments above are abstracts from more detailed analysis that is available separately.

The ECB is widely expected to cut its deposit rate next week and to announce a restart of its QE (bond purchase programme) from October.

Previous non-standards monetary policy measures – the expanded asset purchase programme (APP), the introduction of negative deposit rates and the targeted longer-term refinancing operations (TLTROs) –  all contributed to a steady and widespread decline in bank lending rates while narrowing their dispersion across countries in the Euro Area (EA).

Since the announcement of the credit easing package in early June 2014, lending rates have declined significantly more than market reference rates and policy rates.

In the household (HH) sector, EA lending rates have fallen 134bp since May 2014 compared with a 25bp reduction in the Main Refinancing Rate (MRR) and a 69bp reduction in 3M EURIBOR.

The largest contraction in HH lending rates have been seen in Portugal (-201bp), France (-175bp), Italy (-164bp) and Belgium (-156bp).

In the corporate (NFC) sector, EA lending rates have fallen 123bp over the same period, with relatively large contractions in Portugal (-320bp), Spain (-193bp), and Italy (-192bp).

These trends are entirely consistent with the stated goal of the ECB to “ensure that businesses and people should be able to borrow more and spend less to repay their debt.” They also represent a clear shift in the balance of power from lenders to borrowers.

With 2Q19 results showing the negative impact of these trends on EA banks’ profitability levels (volume growth insufficient to compensate for spread erosion) and with EA banks’ share prices underperforming and trading at discounts to their tangible book value, the key question this week is not will the ECB cut rates and/or restart QE, but will they introduce measure to compensate banks for the obvious negative side effects of negative interest rates.

Please note that the summary comments above are abstracts from more detailed analysis that is available separately.