QE – Chris Mallin Macro Perspectives

“Fuelling the Fire, Part II”

Addressing a major weakness in the current debate about debt

The key chart

**Trends in COCO- and FIRE-based lending (EUR bn, % total) since 2005** (Source: ECB; CMMP)

The key message

A major weakness in the current debate about debt in the “post-Covid world” is the failure to distinguish adequately between different forms of credit.

CMMP analysis, in contrast, draws a clear distinction between productive, “COCO-based” credit and less-productive, “FIRE-based” credit (see “Fuelling the FIRE, the hidden risk in QE”). This enabes a more accurate critique of current macro policy and a better understanding of the implications of unorthodox monetary policy (QE).

The shift towards greater levels of FIRE-based lending pre-dates the introduction of QE, but it was not until July 2016 that this form of credit exceeded COCO-based lending for the first time in the EA. The latest ECB data shows that FIRE-based lending now accounts for 52% of total lending (November 2020) reinforcing my September 2019 message that the “hidden risk in QE is that the ECB is ‘fuelling the fire’ with negative implications for leverage, growth, financial stability and income inequality in the EA.”

COCO- versus FIRE-based lending – the key concepts

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

**Trends in outstanding stock of COCO-based loans since 2005** (Source: ECB; CMMP)

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)

**Trends in outstanding stock of FIRE-based loans since 2005** (Source: ECB;CMMP)

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.

COCO- versus FIRE-based lending – the evidence from the euro area

**Split in lending between COCO-based and FIRE-based credit** (Source: ECB; CMMP)

At the end of November 2020, COCO-based lending in the EA totalled EUR 5,437bn. This is below the peak level of EUR 5,517bn recorded in January 2009. FIRE-based lending, in contrast, totalled EUR 5,792bn, 26% higher than the outstanding stock as at the end of January 2009. As can be seen in the chart above, FIRE-based lending exceeded COCO-based lending for the first time in July 2016. The current split of total loans is now 52% FIRE-based and 48% COCO-based, compared with respective shares of 45% and 55% in January 2009.

**NFC lending as a percentage of GDP since 2005** (Source: BIS; CMMP)

In other words, the shift towards increased FIRE-based lending pre-dates the introduction of QE in the EA. The shift becomes more noticeable in the post-GFC period and may also reflect the fact that NFC debt levels (expressed as a percentage of GDP) had exceeded the threshold level that the BIS considers detrimental to future growth for most of this period (see chart above).

COCO- versus FIRE-based lending – the impact of QE

Nevertheless, as noted back in September 2019, 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’s missing chart”

The FSR is suitably cautious, but misses a key chart

The key (missing) chart

Are ECB policies fuelling growth in less productive FIRE-based lending at the expense of productive COCO-based lending (% total loans)? What are the implications for leverage, growth, stability and income inequality?
Source: ECB; Haver; CMMP analysis

Summary

The ECB published its November 2019 Financial Stability Review (FSR) this week with a suitably cautious outlook for financial stability, economic growth, and banking sector profitability in the euro area (EA).

The analysis is as insightful and thorough as usual and supports many of my current views. However, it “falls short” in one key respect – the FSR presents its analysis through the traditional household (HH) versus corporate (NFC) framework, rather than through the increasingly more relevant COCO versus FIRE-based credit framework.

The risk here is that it underplays the hidden risks in QE, namely that the majority of credit in the EA is directed into “unproductive” FIRE-based credit rather than more “productive” COCO-based credit. As such, current policies to support/stimulate credit demand have potentially negative (if unintended) implications for leverage, growth, stability and income inequality.

Key messages from the FSR (Nov 2019)

The FSR states that the “the euro area financial stability outlook remains challenging“. It highlights four key issues:

Signs of asset mispricing suggest potential for future correction
Lingering private and public sector debt sustainability concerns
Growing challenges from cyclical headwinds to bank sector profitability (“75% of EA significant banks have ROE < 8%”)
Increased risk-taking by nonbanks may pose risks to capital market financing

In mitigation, the FSR notes that: (1) euro area banks are adequately capitalised with a 14.2% CET1 ratio; and (2) all Euro Area countries have activated macroprudential measures. Nonetheless, it concludes that “more active use of macroprudential policies could be appropriate to contain vulnerabilities“.

The FSR argues that the economic outlook has deteriorated and that growth is expected to remain subdued for longer, with risks tilted to the downside. It also concludes that “while the banking sector is resilient to near-term risks, challenges from a more subdued profitability outlook remain“. Four headwinds facing banks are cited: eroding interest margins; slightly higher costs of risk; high cost inefficiencies, and plateauing capital positioning.

I have covered many of these factors in recent posts including:

The ECB’s framework

The FSR presents its analysis of the HH and NFC sector separately. The HH sector is discussed in Section 1.3 (Euro area household resilience supported by low interest rates) and the NFC sector in Section 1.4 (Emerging pockets of corporate sector vulnerability).

**Robust or subdued? Nominal HH credit growth is much lower than in past cycles (%YoY) and concentrated geographically (France, Germany, Benelux)**
Source: ECH; Haver; CMMP analysis

In summary, the FSR describes HH lending as “robust, with continued divergence across countries and types of loans”, HH indebtedness stable (with considerable heterogeneity across EA countries) and risks to HH debt sustainability contained. My comments:

HH credit is growing at the fastest rate in the current cycle (3.4% nominal and 2.6% real YoY growth) but rather than robust, I would describe this growth as relatively subdued especially in relation to historic cycles
As noted in previous posts, and illustrated in the graph above, HH growth is concentrated in Germany, France and the Benelux
In “Debt dynamics in the developed world” I agreed with the conclusion that excess credit growth risks in developed economies were relatively contained (and limited largely to non-EA countries such as Norway, Switzerland, Canada and Sweden, see graph below).

**CMMP analysis shows that HH sector growth risks are relatively low (HH RGF versus HH debt ratio)**…
Source: BIS; Haver; CMMP analysis

**…as are HH affordability risks in the Euro Area in contrast to Norway, Canada and Sweden (HH DSR as at end 1Q19 and deviations from LT average)**
Source: BIS; Haver; CMMP analysis

In the NFC sector, the FSR highlights the deceleration in corporate profits, along with increases in external financing and slightly elevated corporate indebtedness, but suggests that risks are offset by favourable financing conditions and large liquidity buffers.

**NFC debt levels remain above the average for BIS reporting countries and the BIS maximum threshold**
Source: BIS; Haver; CMMP analysis

**CMMP analysis shows that only Italy, Greece and Germany (among large EA economies) have NFC debt levels below the BIS maximum threshold**
Source: BIS; Haver; CMMP analysis

I would suggest that this underestimates risks in this sector:

The NFC debt ratio (% GDP) is currently 105% in the EA, above the 94% average for all BIS reporting countries and the BIS maximum threshold level of 90%
At the country level, only Italy, Germany and Greece have NFC debt ratios below the BIS threshold
My analysis also highlights relative high “growth” and “affordability” risks in the French NFC sector.

**France is among the four economies that have seen the fastest rates of “excess NFC credit growth” despite having high levels of NFC (% GDP)**…
Source: ECB; Haver; CMMP analysis

**…while also displaying relatively high levels of NFC affordability risk (NFC DSR as at end 1Q19 versus deviation from LT average)**
Source: BIS; Haver; CMMP analysis

An alternative framework

In September, I presented an alternative framework for analysing global debt dynamics. I argued that, in its broadest sense, lending can be split 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”-based lending (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”-lending (FInancials and Real Estate).

**EA lending is increasingly directed towards less productive FIRE-based lending (% total lending) which now accounts for 55% of total loans**
Source: ECB; Haver; CMMP analysis

In short, COCO-based lending typically supports production and income formation, while FIRE-based lending typically supports capital gains through higher asset prices. Lending in any economy will involve a balance between these different forms, but to repeat the key point from September: a shift from COCO-based lending to FIRE-based lending reflects different borrower motivations and different levels of risks to financial stability.

**Only three of the large EA economies have COCO-based lending above (Greece, Austria) or equal to (Italy) FIRE-based lending (% total loans)**
Source: ECB; Haver; CMMP analysis

Over the past twenty years, FIRE-based lending has increased from 48% of total loans to 55% as at the end of September 2019. The current level represents the highest share of FIRE-based lending. Only three of the large EA economies have COCO-based lending above or equal to FIRE-based lending: Greece; Austria, and Italy.

Why does this matter?

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.

Leverage: while COCO-based lending increases absolute debt levels, it 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
Growth: 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
Stability: 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. The FSR notes that house prices rose faster than GDP in 1H19 and highlights signs of overvaluation, which now exceeds 7% on average, “but with a high degree of cross-country heterogeneity” (see graphs below)
Inequality: the returns from FIRE-based lending are typically concentrated in higher-income segments of the populations, with any subsequent wealth-effects increasing income inequality.

EA house prices have risen faster than GDP in 1H19 and are estimated to be overvalued by 7%
Source: ECH; Haver; CMMP analysis

**Residential property prices are estimated to be overvalued in all large EA economies (and in the UK) with the exceptions of Italy and Ireland**
Source: ECH; Haver; CMMP analysis

Conclusion

The FSR’s outlook for financial stability, economic growth and bank sector profitability is in-line with the views expressed in my recent posts (albeit with some differences in emphasis). However, the hidden risks associated with the ECB’s unorthodox monetary policy are potentially understated, in my view.

The alternative framework presented here, that draws the distinction between productive COCO-based lending and unproductive/less-productive FIRE-based lending, provides a clearer perspective of these risks.

The on-going shift in the balance of lending in the Euro Area has negative implications for leverage, economic growth, financial stability and income inequality.

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

“Debt dynamics in the developed world”

The developed world continues to deleverage but risks remain

The key chart

**Only Italy, Austria, Greece, Germany and the US have NFC and HH debt ratios (% GDP, 1Q19) below BIS “maximum threshold” levels (dotted red lines)**
Source: BIS; Haver; CMMP analysis

Summary

The developed world continues to deleverage. This process has already led to dramatic shift in the structure of global private sector debt (see “The Changing Face of Global Debt”). With private sector debt levels still “too high” in the developed world, this trend is set to continue.

Risks associated with excess credit growth in the developed world are lower than in past cycles and remain concentrated by economy (Sweden, Switzerland, Canada and France) and by sector (NFC credit more than HH credit). Despite lower borrowing costs, affordability risks are still evident is both the NFC (Canada, France) and HH sectors (Norway, Canada, and Sweden).

Progress in dealing with the debt overhang in the Euro Area remains slow and incomplete. Long term secular challenges of subdued GDP, money supply and credit growth persist while unorthodox monetary policy measures risk fuelling further demand for less-productive “FIRE-based” lending with negative implications or leverage, growth, stability and income inequality (see “ Fuelling the FIRE” – the hidden risk in QE).

Trends in DM debt ratios

Aggregate private sector debt ratios for the Euro Area, and the BIS sample of advanced and emerging economies (% GDP) – the developed world continues to deleverage while the emerging world plays “catch-up”
Source: BIS; Haver, CMMP analysis

The developed world continues to deleverage. Private sector credit as a percentage of GDP has fallen from a peak of 181% in 3Q09 to 162% at the end of the 1Q19. This has involved a (relatively gradual) process of “passive deleveraging” where the stock of outstanding debt rises but at a slower rate than nominal GDP.

The process of deleveraging in the Euro Area started later. Private sector credit as a percentage of GDP peaked at 172% in 1Q15 and has fallen to 162% at the end of 1Q19, in-line with the average for the BIS’ sample of advanced economies.

**The outstanding stock of debt continues to rise ($ billion) but at a slower rate than nominal GDP**
Source: BIS; Haver; CMMP analysis

This process has led to a dramatic shift in the structure of global debt. In 1Q00, the advanced world accounted for 90% of global private sector credit, with advanced economies excluding the Euro Area accounting for 70% and the Euro Area 20%. Emerging markets accounted for only 10% of global private sector credit with 7% from emerging markets excluding China and 3% from China.

**The changing face of global debt (% GDP) – shifting East and towards emerging markets**
Source: BIS; Haver; CMMP analysis

At the end of 1Q19, the advanced world’s share of global debt had fallen to 64% (advanced economies ex Euro Area 47%, Euro Area 18%) while the emerging markets share has increased to 36% (EM ex China 12%, China 24%).

Where are we now?

**The key chart repeated. The Netherlands, Sweden, Norway, Canada, Switzerland and Denmark have** **NFC and HH debt ratios (% GDP, 1Q19) above BIS threshold levels (dotted red lines)**
*Source: BIS; Haver; CMMP analysis*

With debt levels remaining “too high” in the advanced world this trend is likely to continue. The BIS considers corporate (NFC) and household (HH) debt ratios of 90% and 85% respectively to be maximum thresholds above which debt becomes a constraint on future growth.

In our sample of advanced economies, only Greece, Germany, Italy, Austria and the US have debt ratios below these thresholds in both sectors. In contrast both NFC and HH debt levels are above the BIS thresholds in the Netherlands, Sweden, Norway, Switzerland, Denmark and Canada. NFC debt ratios remain above the threshold in Ireland, Belgium, France, Portugal and Spain and while the UK has “excess” HH debt. In short, progress towards dealing with high levels of private sector debt remains incomplete.

Associated risks

Private sector growth risks

**The highest rates of “excess credit growth” (3-year RGF 1Q19) have occurred in economies where PSC debt levels are already high: Switzerland, Sweden, Canada, France**
Source: BIS; Haver; CMMP analysis

Risks associated with “excess credit growth” in developed markets are lower than in past cycles. I introduced my Relative Growth Factor analysis in “Sustainable debt dynamics – Asia private sector credit”. In short, this simple framework compares the relative growth in credit versus GDP (3 year CAGR) with the level of debt penetration in a given economy.

**Among the high risk economies, Canada has seen the most obvious adjustment (trends in 3-year RGFs since March 2002)**
Source: BIS; Haver; CMMP analysis

In terms of total private sector debt, the highest “growth risks” can be seen in Sweden, Switzerland, Canada and France. Private sector credit in each of these economies has outstripped GDP growth on a CAGR basis over the past three years despite relatively high levels of private sector debt. Canada has made the most obvious adjustment among this sample of relatively high risk economies with the RGF falling from over 4% two years ago to 1.8% currently.

NFC sector growth risks

In the NFC sector, the highest risks can be observed in Switzerland, Sweden, Canada and France. RGFs for these for these economies were 3.9%, 3.0%, 2.7% and 1.8% respectively, despite NFC debt levels that are well above the BIS threshold. As above, Canada’s rate of excess NFC credit growth is slowing in contrast to trends in Switzerland and Sweden.

**Contrasting trends between NFC sector risks in Canada versus Switzerland and Sweden**
Source: BIS; Haver; CMMP analysis

HH sector growth risks

In the HH sector, RGF analysis suggest that the highest risks are in Norway, Switzerland, Canada, Norway (and the UK). RGFs in these economies were 1.3%, 1.1%, 0.7% and 0.4% respectively. In other words, excess HH credit growth risk is lower than in the NFC sector. Furthermore, the rates of excess HH credit growth in each of these economies is lower than in the recent past, especially in Norway and Canada.

**Rapid adjustments in Norway and Canada among relatively high HH sector growth risk economies**
Source: BIS; Haver; CMMP analysis

Affordability risks

Despite lower borrowing costs, affordability risks remain. BIS debt service ratios (DSR) provide, “important information about the interactions between debt and the real economy, as they measure the amount of income used for interest payments and amortisations.” (BIS, 2017). The perspective provided by DSRs complements the analysis of debt ratios above but differs in the sense that they provide a “flow-to-flow” comparison ie, the debt service payments divided by the flow of income. In the accompanying charts, DSR ratios for private sector, corporate and household credit are plotted against the deviation from their respective long term averages.

**Canada and France display the highest NFC affordability risk levels (1Q19 DSR versus LT average)**
Source: BIS; Haver; CMMP analysis

NFC affordability risks are highest in Canada and France. Debt service ratios (57% and 55% respectively) are not only high in absolute terms but they also illustrate the highest deviations from their respective long-term averages (47% and 49% respectively). In the HH sector, the highest affordability risks are seen in Norway, Canada and Sweden, although the level of risk is lower than in the NFC sector.

**Norway, Canada and Sweden display the highest HH sector affordability risk (albeit lower than in the NFC sector)**
Source: BIS; Haver; CMMP analysis

Implications for the Euro Area

Progress in dealing with the debt overhang in the Euro Area remains slow and incomplete. Long term secular challenges of subdued GDP, money supply and credit growth persist. The European Commission recently revised its 2019 forecast down by -0.1ppt to 1.1% and its 2020 and 2012 forecasts down by -0.2ppt to 1.2% in both years, with these forecasts relying on “the strength of more domestically-oriented sectors.

**Subdued Euro Area growth forecast to continue (% YoY)**
Source: European Commission; Haver; CMMP analysis

Growth in broad money (5.5%) and private sector credit (3.7%) in September remains positive in relation to recent trends but relative subdued in relation to past cycles. Furthermore, the renewed widening in the gap between the growth in the supply of money and the demand from credit (-1.8%) indicates that the Euro Area continues to face the challenge of deficiency in the demand for credit.

**Gap between growth in supply of money and demand for credit illustrates the fundamental problem – a deficiency in credit demand across the Euro Area (% YoY, 3m MVA)**
Source: ECB; Haver; CMMP analysis

This has on-going implications for policy choices. Unorthodox monetary policy measures risk fuelling further demand for less-productive “FIRE-based” lending with negative implications or leverage, growth, stability and income inequality (see “ Fuelling the FIRE” – the hidden risk in QE).

**“Fuelling the FIRE” – split in EA lending over the past twenty years between productive (COCO) and less productive (FIRE) based lending (% total lending)**
Source: ECB; Haver; CMMP analysis

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

“Fuelling the FIRE” – the hidden risk in QE

The hidden risk in QE is that the ECB is fuelling the growth in FIRE-based lending with negative implications for leverage, growth, stability and income inequality

**“Fuelling the FIRE” – spilt in EA lending over past twenty years between productive (COCO) and less productive (FIRE) based lending (% total loans)**
Source: ECB; Haver; CMMP

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

**The (real) cost of borrowing for EA households (HH) and corporates (NFC) has declined since the Fourth Phase began in July 2014**
Source: ECB; Haver; CMMP

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”.

**“Shifting the balance of power” – trends in official (MMR), ST money market (3m Euribor) and household (HH) and corporate lending (NFC) rates since end May 2014 (change in bp)**
Source: ECB; Haver; CMMP

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.

**Growth in HH lending is subdued in relation to past cycles and dominated by growth in Germany and France** (% YoY)
Source: ECB; Haver; CMMP

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.

**Growth in NFC lending is also subdued in relation to past cycles and also dominated by Germany and France (% YoY)**
Source: ECB; Haver; CMMP

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.

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

**Share of total EA lending (%) accounted for by COCO-based lending (1999-2019)**
Source: ECB; Haver; CMMP

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)

**Share of EA lending (%) accounted for by FIRE-based lending (1999-2019)**
Source: ECB; Haver; CMMP

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%).

**As of July 2019, only three of the large EA economies have COCO-based lending above or equal to FIRE-based lending (% total lending)**
Source: ECB; Haver; CMMP

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.

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.

“Power to the Borrowers” – who are the winners from QE?

Watch to see if the ECB introduces compensation measures for banks this week

**Trends in official ECB and ST money market rates (%)**
Source: ECB; Haver, CMMP

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.

**QE in action – scale (EUR mn) and breakdown by instrument**
Source: ECB; Haver, CMMP

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).

**Falling (real) cost of borrowing for EA households and corporates**
Source: ECB; Haver; CMMP

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).

**Shifting the balance or power: cost of borrowing for households and corporates has fallen faster than ST money market and official rates (change in bp since end May 2014)**
Source: ECB; Haver; CMMP

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.

**Shifting balance of power reflected in underperformance of SX7E (leading EA banks) versus SXXE**
Source: Haver; CMMP

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.