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Posted by: Deepa Vasudevan on Mon, Jun 9th, 2014

ECB: Easing into negative territory

Last week the European Central Bank made history by shifting to negative interest rates. Starting June 11, banks in the Euro area will not receive interest- instead- they will pay 0.1 per cent interest when they deposit cash with the ECB. This applies to all deposits over the minimum reserves to be maintained with the Central Bank.  Simultaneously, the main refinance rate has been dropped from 0.25% to 0.15%. To draw a parallel with India, it is akin to having a repo rate of 0.15% and a reverse repo rate of minus 0.1% (please note that the actual rates for India are 8% and 7% respectively).

 

Of course, the negative interest rate does not apply to ordinary savings accounts or fixed deposits, it is only relevant to the accounts held by banks with the Central Bank. Most bank deposits in Europe still pay low but positive interest rates.

 

The monetary easing was widely expected, though the negative rate announcement caused a bit of a stir. The ECB has, in fact, been steadily cutting its benchmark rates since 2008. And deposit rates have actually been at zero % since July 2012 (Pic 1).

 

Pic 1 Key Rates in the Euro Area

 

Pic 1 Key Rates in the Euro Area

Source: www.ecb.europa.eu

 

But despite the rate cuts, bank credit, especially to small and medium enterprises, has not picked up. An additional problem is the appreciation of the Euro. A stronger Euro has harmed exports from Europe, and reduced the chances of an export driven growth recovery.  Cheaper imports have kept inflation down, and created disinflationary pressures. 

 

Real economic growth declined by 0.7% in 2012 and 0.4% in 2013. The ECB’s mandate is to maintain inflation at around 2%, but inflation has been below 1% for some months now. It was at 0.5% in May (Pic 2).

 

Pic 2 Consumer Price Inflation in the Euro Area

 

Pic 2 Consumer Price Inflation in the Euro Area

Source: www.ecb.europa.eu

 

Faced with declining growth rates and a risk of deflation, the Central Bank had no option but to ease monetary policy further. The ECB hopes to accomplish two main objectives with its negative rate shocker. The first is to stimulate growth by supporting bank credit. Since banks will, effectively, be penalised for holding deposits with the ECB, they are expected to lend out the money instead. And, as an incentive, additional measures to support lending were announced. These include a series of targeted long term refinancing operations to improve bank lending to households and private non-financial businesses; loans at the main refinancing rate for banks provided they can show that they have increased lending to businesses; and most important, the promise of preparing for eventual purchases of asset backed securities from banks to increase their capital.

 

The second unstated but obvious goal is to depreciate the euro, or at least, stop its appreciation. The rationale is that faced with declining interest rates, investors will pull out funds and that in turn will bring down the exchange rate of the Euro.  

 

Both goals will be tough to achieve. There is no guarantee that interest rate cuts will result in greater flow of bank credit. Banks in Europe are still stuck with bad loans. Borrowers are often not sufficiently credit worthy during a slowdown.  And there is a fear that the banking system may not be sufficiently well capitalised or risk protected to handle another crisis. The environment, therefore, is not conducive for a surge in credit.

 

And as for the exchange rate, it has actually appreciated slightly in the days following the ECB policy action. Market news attributes this to the rush of money to the periphery Euro countries- such as Italy and Spain- where yields still remain relatively high.

 

What does this mean for India? If growth in the Euro area does pick up, it will help our economy. The Euro Zone is the one of our largest importers, accounting for 16% of goods exports in dollar terms. And if growth worsens, India will lose export revenues from Europe, but could probably make it up by exporting more to the US and to other Asian countries where growth seems to be reviving. In any case, financial markets are more affected by the policy actions of the US Federal Reserve. It is almost certain that interest rates in the US will rise soon, and its quantitative easing program will be tapered off. That may cause reverse flow of capital from emerging economies to the US. It is in India’s interest to prepare for that eventuality by putting its domestic policies in order and improving its own economic growth. 

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