In its simplest form, monetary policy around the developing world is centered on adjusting the lending rates so as to trim or boost credit. The mission of the European Central Bank (ECB), the decision maker for the Euro Area, is however more complicated than elsewhere; to be more accurate, its assignment became more challenging in the aftermath of the sovereign crisis which severely reduced the synchronization of the euro area members’ economic cycle and reminded investors that despite the unique currency, the member countries should not carry the same country risk premium.

In this context, the abrupt cut in the key interest rate (from 4.25% in 2008 to 0.25% presently) did not help much in boosting credit and, as a result, the growth has remained subdued. Why did this happen? Given the deep concerns about the health of the banks (particularly the peripheral ones) and changes in the regulatory regime, banks adopted a cautious attitude and started building liquidity buffers in lieu of lending the excess to their peers or to the real economy. ECB then took some bold steps and increased funding, including long term liquidity funding (LTRO), while buying covered and sovereign bonds so as to drive yields lower and shield banks from asset quality worries. The unconventional measures were in particular meant to keep the cost of bank funding at bay notwithstanding the sovereign crisis. As a result, the ECB’s balance sheet expanded to EUR3 trillion in December 2012 from EUR1.5 trillion in December 2007; in March 2014 it stood at a lower EUR2.2 trillion following the reimbursement of some of the LTRO.

Even so, the results were deterred by the banks’ preference for holding excess liquidity, with actually a large chunk of the funding being “parked” at the ECB in deposits. The situation normalized gradually relative to 2012 but we are still to see a recovery in credit. What’s more, while such a large expansion in the central bank’s balance sheet has the potential to fuel hyperinflation in normal market conditions, the inflation has repeatedly failed to meet expectations and stood at only 0.5% in March.

As economists say, these are symptoms of a malfunctioning monetary policy transmission mechanism, which in turn is equivalent to weak, if any, growth as European corporates are known to rely on bank funding to a larger extent than their US counterparts (70% comparing to less than 20% in US, according to ECB); relatedly, SMEs are keystone for the European economy and they can make limited recourse to market funding.

Looking at the latest credit data published by the ECB just last week serves to depict how high are the challenges faced by the euro area policymakers are. In February, the flow of credit to private euro area residents was EUR -11.4 billion, with non-financial corporates (NFC) accounting for most of the decline; indeed, the figure for households was marginally positive when adjusting for seasonal factors. Perhaps even more illustrative are the cumulative amounts for the last 12 months as they show a EUR140 billion drop in corporate lending and a more heartwarming EUR18 billion uptick in household credit.

Still, our analysis cannot end without a review of the country-level data and here is where we find persistent reasons for worrying. Specifically, as we more clearly show in the charts below, only Germany, France, Finland, Belgium and, to a smaller extent, Slovakia show the positive flows specific to a functioning bank system (and, by extension, monetary transmission mechanism); at the other end, we find the peripheral countries.

To sum up, the European financial system remains fragmented which prevents the effective transmission of the ECB’s monetary efforts and results in a perpetuation of the growth gap between the peripheral and core countries. Under these conditions, the monetary authorities have limited scope for renewing their Quantitative Easing (QE) and they would probably be more successful by incentivizing banks to decrease cash buffers (for example through negative deposit rates) and by designing measures directly targeting the reviving of the lending activity. One step in this direction was already taken last week when the European Commission announced a package of measures meant to support long term financing, including securitization: “Securitization, which is something the European Central Bank has supported, is a key instrument to release funding for SMEs. There are low quality securitizations like subprime loans and such, but there are high quality securitizations. What we want to do with the rules, in conjunction with the ECB, is encourage good securitization and make a distinction between good and bad securitization". Other measures that would serve a similar aim would be accepting loans as collateral for Central Bank financing or mandating that the funding raised from ECB has to be used for lending (similarly to Bank of England’s “Funding for lending” scheme).

We would however see the ongoing Asset Quality Review as a possible factor for additional QE given that the banks from non-core countries could see their cost of funding increase as thy are prone to greater concerns; nevertheless, for now this exercise did not spark risk aversion; on the contrary, March marked the return to markets of the Greek banks with the sovereign expected to follow sometime in April.

Have a nice day,