Last Thursday, European Central Bank (ECB) President Mario Draghi announced the bank’s latest steps in an effort to boost Europe’s economy — it will start buying bonds that are backed by loans to companies or individuals. The details will only be known in October, but we don’t need to see them to know that this is not a panacea for Europe’s problems.
It is true that bank loans to corporations have been shrinking since 2008. But that is because the credit-worthiness of most corporates, particularly small and medium-sized enterprises (SMEs), has fallen significantly, and thus banks are not really eager to finance them, or if they are, they include the added risk to the prices charged. In addition, the finances of SMEs have fallen due to the recession we have faced in the last years. On the other hand, large European Union (EU) corporates have cash holdings at historical highs. This means they cannot find, in the current economic depressive environment, good investment opportunities and prefer to keep the money in their coffers.
Another problem with the recent ECB announcement is that, though well-intentioned, unfortunately this will not have much of an impact due to the limited size of the loan-backed bonds in Europe. Since the 2008 crisis, the securitization market in Europe is at very low levels, which is fundamental for the existence of these asset-backed bonds.
With the limited issuance of asset-backed bonds in Europe, the ECB plan will be slow to have any impact.
Instead, the ECB should have announced similar plans three or four years ago, which should have been extended to the purchases of government bonds. This was what the United States Federal Reserve (FED) did — commonly known as quantitative easing — buying trillions of dollars’ worth of bonds, in order to avoid being in the situation Europe is now: stagflation.
Purchases of government bonds are clearly more complicated to implement in Europe than the US. Choosing which bonds to buy in Europe, since each country issues them separately with different risks, is not easy. What should the portfolio weights of the ECB be when buying sovereign bonds? Should it buy only southern European bonds? These are tough questions, but had the ECB acted three years ago, as the FED did, we could have avoided this European-wide stagnation that we currently face.
By not acting in time, due to all the political disagreements in the Euro area, the ECB missed its timing, and allowed interest rates to reach abnormally high levels in 2011-2012 as well as allowed the Euro to appreciate versus the USD. This hammered Euro exports, and ultimately led many European countries into recession due to austerity policies at a time when reforms were needed. Now, three years later, sovereign yields are at historical lows, and it is clear that the ECB has no longer any role to play here.
The current ECB plan will, however, allow banks to offload some of their loan-backed bonds to the ECB, and thus receive cash. Whether they lend that cash again to companies is a totally different story. They are not forced to. But in any case, the cash infusion will allow banks to meet capital targets in the upcoming stress tests giving them an easier time when the tests come. It should also help alleviate the pressure on the Euro, which is good for European exporters.
Overall, the leadership of Mario Draghi has been strong, but severely damaged by the political debacles that have paralyzed Europe for the last five years. Necessary reforms still need to be implemented. The common good of the EU must become a priority. But current politicians, unfortunately, have shown that they are not capable of making it such.
Even though the timing is off, Draghi is doing his share of the work. But he cannot end Europe’s woes all by himself.
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