The ECB’s Gamble

World trade prices are currently falling at probably their fastest pace since the dark days of the Global Financial Crisis and, in so doing, they are imparting a significant deflationary bias to the world economy. We find that even in some of the world’s strongest economies such as the US and the UK, as well as here in New Zealand, retail prices are either simply falling or rising at a much slower pace than many would have expected.

Wednesday, March 4th 2015, 12:27PM

by Andrew Hunt

The ultimate cause of this deflation is North Asia’s inability to reform and dismantle its once heavily protected and favoured manufacturing sectors at a time when the Western economies no longer possess their once-insatiable demand for imports of consumer goods. Certainly, Japan, China and Korea each relied on their respective manufacturing sectors for their initial economic development but these models have been allowed to persist for too long; the nature of the world economies has changed but these countries have not yet been able to adapt to these new circumstances, with the result that some considerable part of their recent output growth has simply found itself piling up in unsold inventories.

These countries have continued to actively “protect” their existing economic structures either by using overt weak currency policies (Japan) or less transparent subsidies and other means. Somewhat ironically, the financial markets may have fawned over Abenomics but, in reality, it has been a primary source of the current bout of global trade deflation that is both causing analysts to pare back their corporate earnings forecasts and leading many policymakers to become concerned.

There has become something of an element of the “Prisoners’ Dilemma” involved in many countries’ reactions to the increase in North-Asian-sourced price deflation. In a “perfect world”, the world’s policymakers might meet under the auspices of the IMF and agree a plan in which they all promised not to devalue but to attempt to boost their own economies. The IMF, though, has perhaps never really been able to live up to its founders’ ideals in this regard and certainly its current leadership has not been able to prevent countries going it alone and pursuing their own weak currency agenda.

Perhaps the previous boss of the IMF might have been more suited to the task of forcing countries to coordinate their individual responses to the deflation threat but he is otherwise engaged. Instead, we have many countries seeking to ensure that they are not the economy that is left with the “uncompetitive exchange rate” in what seems to have become a race to the bottom. Clearly, for the global economy this race to the bottom in the currency markets can only heighten the ongoing risk from deflation and also the threat to corporate earnings but, rather ironically, this turn of events has proved positive for financial markets.

At an unstructured level, we find that financial markets have responded to “yet more QE” quite positively but we should also note that the race to the bottom in currencies has resulted in huge capital inflows into the US. These capital inflows have not only lifted US asset prices directly, they have also created a surge of deposit funding into the US banking system. For the US banks, these large inflows have proved something of a poisoned chalice that has obliged the banks to begin charging their corporate customers to hold deposits in dollars. Despite even this seemingly drastic measure, though, the banks have still been taking in funds which they in turn have been forced to deploy. With credit demand within the US real economy still notably subdued, the banks have only really been able to deploy them via an increase in their holdings of trading assets and via an increase in lending to their financial sector subsidiaries.

Intriguingly, so intense has this activity been that at times it has been creating as many new dollars for the financial markets each week as the Federal Reserve’s old QE3 regime used to create in a month. The result has so far at least – not surprisingly – proved to be very positive for financial markets.

It is not only in the US that we find that financial sector liquidity trends have improved of late – the same appears to be true in Europe. At an aggregate region-wide level, we find that the Eurozone banking system is expanding once again on the back of a number of factors. Firstly, there has been a (very modest) improvement in household sector credit growth (principally in Germany, which is perhaps the very country in which the ECB wants to see a credit boom) and there have also been some signs of a stabilisation in non-financial corporate sector credit levels.

We find, though, that the primary “driving forces” behind the recent improvement in total credit and monetary growth within the European system have been the relatively large scale purchases of government bonds by the commercial banks (as the latter have presumably attempted to front-run the ECB’s QE policy) and a sharp increase in the banks’ acquisitions of assets overseas. We suspect that these were the very types of events that Draghi had hoped to witness when the ECB first started to “drop hints” over the likely implementation of a QE plan.

Unfortunately, we believe that what is happening within the Eurozone could actually turn out to be quite dangerous. Under the ECB’s rather cobbled together QE plan, it will be the individual national central banks within the Eurozone that will purchase the required sovereign bonds on the ECB’s behalf and, as a result of the unusual nature of the ownership of the European bond markets in which the majority of the outstanding debt is actually owned by foreign investors, many, and perhaps the outright majority, of these bond purchases will either be from foreign investors (who we can assume are only holding these bonds because they are waiting for the ECB to buy them out at higher prices – this would certainly seem likely to be the case in France) or domestic investors who have already revealed a marked preference to spirit funds offshore (for example, Italy). Consequently, it seems very unlikely that many of proceeds of the liquidity injections will “stick” within the countries in which they occur and instead the funds will likely as not either flow into the core countries (thereby possibly pushing German Bund yields ever lower) or they will leave the Eurozone completely.

As a consequence of the latter, we suspect that the Euro will likely continue to fall against the USD until such time as enough USD and other currency-based entities decide that the Euro is now so “cheap” that they must acquire Euro-denominated assets once again or simply purchase European exports. At that point, funds should start to flow back into the Eurozone and the Eurozone’s aggregate balance of payments position will automatically begin to balance once again – this is after all how floating exchange rates are supposed to work. This is not to say, though, that the funds will flow back into the same countries from which they originally emanated.

The performance of German equities, bonds and even property suggest that as the Euro has fallen, Germany has likely gained a disproportionate share of the return inflows. Other things being equal, this situation would lead one to assume that although Europe’s aggregate balance of payments will return to balance as a result of the weaker Euro, there could potentially be wide imbalances created by this process within the Euro area itself with Germany, Finland and perhaps Luxembourg witnessing the creation of ever larger balance of payments surpluses within the Eurosystem and the other countries significant deficits.

Unfortunately, history shows us that when Germany possesses a balance of payments surplus but the periphery is suffering deficits there tends to be some form of Eurozone Crisis phase. Therefore, for the next Euro Crisis to be avoided, we can suggest that German savers and investors must now preside over massive capital outflows of their own that exceed not only Germany’s (expanding) current account surpluses but also any extra inflows that the country gains as a result of the ECB’s enactment of its QE. This implies that German savers will have to become incredibly active in “buying risk”, be it in the other countries within the Eurozone or outside the area. Unfortunately, these investors will be buying this new higher level of risk exposure at a time in which there seems to be little value around within global markets: equities seem far from cheap given the global economic environment, credit spreads are already compressed and there are few obvious undervalued assets and currencies left to choose from. We might also add that within the case of intra-Eurozone flows, German savers will almost by definition have to, in effect, be moving in the exact opposite direction as the domestic “insiders” (that is, the residents) of the countries concerned, who seem to be intent on quitting their own markets.

In short, German savers are going to have to be encouraged to buy yet more very expensive assets and this may explain why there is so much upward pressure on Germany’s own assets at present – if anything is to appear “cheap” relative to German assets in this world, then German assets are going to have to become very expensive…
If the German private sector were, though, to prove not to be up to this task, then it will fall by default to the public sector and, in all probability, the Bundesbank itself via the infamous TARGET2 system. (TARGET2 is a theoretically fully automated system through which the central banks of Europe’s creditor countries are required to provide infinite quantities of potentially infinite duration credit to the banking systems of the deficit countries.)

At this point, it would be the German state (that is owned by the people...) that was, in effect, buying “expensive risk” and this, we would suggest, would be straying into the type of de facto or potential fiscal transfers that seem to have already been ruled out by the German government. As former ECB member Stark described so eloquently in the Financial Times last month, the Euro is not a federation and there is no reason to believe that Germany, through either its public or private sectors, should be expected to transfer wealth to other countries within the Eurozone that refuse to reform by becoming either the lender of last resort (that is, if the German public sector recycles Germany’s surpluses) or the buyer of last resort (if it is the private sector route).

With this analysis in mind, we find it a little worrying that the ECB’s balance sheet has already started to expand even before the introduction of the QE (which is still some weeks away) and to find that this growth in the central bank’s aggregated balance sheet has been driven by a sharp increase in the level of TARGET2 system lending, a situation that would seem to suggest that even the rumour of an easing of monetary conditions in the weaker economies is beginning to lead to wider intra-regional imbalances within the Eurozone. This conclusion is further strengthened when we note the recent weakness within the data for the level of customer deposits within many of the peripheral countries’ banking systems (that is, not only in Greece).

It therefore seems to us that although the ECB’s announcement of a forthcoming QE regime may have exerted the desired effect on the aggregate data, financial asset prices and the Euro’s external exchange rate (all things that would have been “welcomed” were Europe a single country) it seems that the effects have been notably differentiated between countries and that the result of this has been an increase in what we might describe as potentially Euro-threatening intra-regional financial imbalances.

It is too soon, we suspect, for these imbalances to pose an existential crisis for the Eurozone but we would note that even before QE has officially been introduced, some of the underlying – and quite basic flaws – in the ECB’s approach are becoming visible. This situation will therefore require further continued monitoring, particularly once the ECB actually enacts its bond purchases via the individual national central banks.

For now, financial markets may have ample liquidity support but the foundations of this support – particularly in Europe – are far from assured. For now, we would suggest that investors enjoy the liquidity ride, but this is one gift horse that should be inspected regularly.

Andrew Hunt
International Economist, London

Andrew Hunt International Economist London

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