Will ECB Policy Actions Spur Growth?

Executive Summary

Recent economic indicators suggest that economic growth in the Eurozone remains very weak and that inflation is quite benign. At its regularly scheduled policy meeting on May 2 the European Central Bank (ECB) reduced its main policy rate by 25 bps, and it committed to keep policy accommodative “for as long as needed.” In our view, the rate cuts are too small to have a meaningful effect on economic growth in the euro area. 

Besides, the level of the ECB’s policy rates is not the main problem faced by the European financial system today. Rather, lending standards are much tighter in peripheral European economies, which continue to struggle with sovereign debt problems, than in the core countries. Lending to the non-financial sector in peripheral European economies is especially weak today.

A solution to the European sovereign debt crisis, which is at the heart of the financial problems in Europe, is beyond the scope of the ECB. However, its initiative in conjunction with other European institutions to develop a securitization market for business loans could eventually help to ease tightness in bank financing markets in some countries that could lead to stronger economic growth. But there are no details at present about this initiative, and its implementation remains well in the future. In the meantime, we continue to forecast that economic growth in the overall euro area will remain weak. 

Economic Activity in the Eurozone Remains Very Weak

As is well known, most economies in the 17-member Eurozone have struggled over the past five years. After enduring a painful recession in which real GDP in the overall euro area contracted nearly 6 percent between Q1-2008 and Q2-2009, modest economic growth resumed in the second half of 2009. However, the intensification of the European sovereign debt crisis caused the Eurozone to slide back into recession at the end of 2011, and the euro area has now endured five consecutive quarters of negative GDP growth. Consequently, the level of real GDP in the Eurozone is currently 3.1 percent below its peak five years ago. In contrast, real GDP in the United States stands 3.2 percent above its pre-recession peak. There was hope coming into 2013 that the Eurozone would exit recession in the first half of the year, but recent data indicate that real economic activity remains weak, and that real GDP in the overall euro area likely contracted for the sixth consecutive quarter in Q1-2013.1 For example, the unemployment rate, which this past year surpassed its previous all-time high, continues to climb ever higher (Figure 1). Moreover, economic weakness appears to be more widespread now than it was a year ago. The economies of most of the highly indebted countries were very weak, but Germany continued to register positive economic growth in 2012.2 Recent data suggest that most of the highly indebted economies continue to contract in 2013, but weakness has now spread to 

Germany as well. The manufacturing and service sector PMIs in Germany are now below the demarcation line separating expansion from contraction, and the Ifo index of business sentiment, which is highly correlated with German industrial production growth, has declined for two consecutive months. The French economy, which was flat in 2012 relative to the previous year, remains dead in the water.

Due largely to the weak pace of economic activity, there are few inflationary pressures in the Eurozone at present. The overall rate of CPI inflation, which had exceeded 2 percent throughout 2011 and 2012, has tumbled recently to only 1.2 percent in April. The core rate of inflation, which excludes volatile items such as food and energy and which is more reflective of underlying inflationary pressures, is only 1.0 percent at present. 

Given these signs of economic weakness and benign inflation, the ECB decided to make three policy steps at its regularly scheduled policy meeting on May 2. First, it decided to reduce the interest rate on its main refinancing operations (MRO), at which the ECB provides the bulk of the liquidity to the banking system, from 0.75 percent, where it had been maintained since July, to 0.50 percent, a new all-time low. The ECB also reduced the interest rate on the marginal lending facility, at which banks can borrow on an overnight basis, from 1.50 percent to 1.00 percent. Second, the ECB committed to provide as much liquidity to the banking system as it desires until at least mid-2014, and it said “our monetary policy stance will remain accommodative for as long as needed.” These commitments should help to reduce any upward drift in market-determined interest rates. Third, the ECB announced that it would consult with other European institutions on an initiative that could potentially spur more lending to non-financial companies, a topic that we will discuss subsequently in more detail. 

Will Rate Cuts Help Spur Growth? 

In our view, the ECB’s interest rate decisions will do little to jumpstart economic growth in the moribund Eurozone economy. Even if banks completely pass on the policy rates directly to their customers, these small declines in rates probably will not induce many businesses and consumers to significantly increase their demand for new loans. Loan growth in the overall euro area has weakened over the past year despite historically low ECB policy rates (Figure 2). Moreover, the broad measure of bank lending in the overall euro area that is shown in Figure 2 fails to distinguish differences in lending conditions among different sectors and among different regions. Specifically, loan growth to the non-financial corporate sector is significantly weaker in the so-called peripheral European countries than in the so-called core European countries at present (Figure 3).3 Loan growth to the household sector in peripheral Europe is also negative at present, although it is not quite as weak as loan growth to the non-financial sector (Figure 4). 

There is also a significant dispersion in interest rates among the 17 euro area economies. To measure the variability of interest rates among individual economies, the ECB calculates coefficients of cross-country variation that are plotted in Figure 5 for the non-financial sector and the household sector.4 The rise in these coefficients over the past few years indicates that businesses and households in different countries within the euro area are paying vastly different interest rates. For example, a non-financial business located in Germany would today pay an interest rate that is less than 3 percent for a €1 million loan with a maturity up to one year (Figure 6). In contrast, banks would charge a business in Italy more than 4 percent for that loan, and a Greek business would pay nearly 7 percent. Before the global financial crisis of 2007-08, interest rates on business loans among these countries were closer than they are today. If the spread between Germany and Greece were the same today as it was in 2007, the Greek business would be paying roughly 300 bps less for that loan than it is today and an Italian business would actually be paying roughly 200 bps less than today.

These sharp differences in loan growth and interest rates among individual economies reflect deeper issues that arguably are beyond the ECB’s ability to address. For example, banks in peripheral European countries that may be undercapitalized may charge higher interest rates than otherwise, assuming they are willing to lend at all to businesses and households. However, bank recapitalization is not part of the ECB’s remit. Rather, it needs to be done by individual governments in conjunction with their European partners. In addition, uncertainties related to the continuing sovereign debt problems in Europe may also be causing some banks to keep their lending standard tighter than otherwise. Painful political decisions both within individual countries and among countries will be required to solve the European sovereign debt crisis, and these decision really are beyond the ECB’s ability to influence.

That said, the ECB has taken a step that may eventually lead to some relaxation in bank financing markets. As noted above, the ECB said that it will start consultations with other European institutions on an initiative that could potentially spur more lending to non-financial companies. Specifically, the ECB would like to develop a market for asset-backed securities that are collateralized by loans to non-financial companies. The idea would be to securitize loans to businesses that are on bank balance sheets and sell those securities to investors. Presumably, banks would be more willing to make loans to businesses if they know they could eventually get those loans off of their balance sheets via securitization. 

Although not as thriving as they were before the global financial crisis, securitization markets play an important role in the American financial system. If the ECB’s consultations bear fruit, securitization could eventually play a more important role in the bank-dominated European financial system than they do today. However, it is impossible to determine the effectiveness of the ECB’s securitization idea because we have no details at this point. It may be months before European authorities put forth a concrete securitization proposal, and it could be even longer before it becomes operational. Therefore, we do not look for a sea-change in the European economic outlook, and expect that economic growth in the Eurozone will remain very weak for the foreseeable future. 

Conclusion 

The Eurozone has been in recession since late 2011 due, at least in part, to very tight lending conditions in some countries. Due to recent signs that economic weakness is becoming more widespread, the ECB decided to reduce its policy rates at its meeting on May 2 and it committed to keep policy accommodative “for as long as needed.” However, we do not look for the rate cuts to lead to stronger growth. For starters, the 25 bps rate cut is just too small to make much of a difference. Second, the level of the ECB’s policy rates is not the main problem faced by the European financial system today. Rather, lending standards are much tighter in peripheral European economies, which continue to struggle with sovereign debt problems, than in the core countries. Lending to the non-financial sector in peripheral European economies is especially weak today. 

A solution to the European sovereign debt crisis, which is at the heart of the financial problems in Europe, is beyond the scope of the ECB. However, its initiative in conjunction with other European institutions to develop a securitization market for business loans could eventually help to ease tightness in bank financing markets in some countries that could lead to stronger economic growth. But there are no details at present about this initiative, and its implementation remains well in the future. In the meantime, we continue to forecast that economic growth in the overall euro area will remain weak.