The European Central Bank’s New ‘Stimulus’ Probably Isn’t Too Stimulating

The European Central Bank (ECB) is attempting to boost the economy! Or at least that is how it—and the financial media we reviewed—are portraying ECB President Mario Draghi’s decision last week to renew the central bank’s “targeted longer-term refinancing operations” (TLTROs). Financial media we surveyed commonly described it as a “major policy reversal” and a “U-turn,” bringing back major economic stimulus.  We think this gives the ECB too much credit. Thursday’s announcement largely extends the status quo—an unnecessary move, in our view. Whilst couched as stimulus, we think it was really designed to defang a false fear: maturing TLTRO loans.

First, understand: TLTROs are not quantitative easing (QE). TLTROs let banks borrow funds for a fixed period directly from the ECB at discounted rates, providing they use them to underpin loans to businesses and consumers. This lowers banks’ funding costs, in theory. By contrast, under QE the ECB bought long-term fixed interest securities to reduce longer-term interest rates, which heavily influence banks’ loan profits. By doing so whilst fixing short rates just below zero, the ECB reduced the difference between short- and long-term interest rates (it flattened the yield curve, in industry parlance). Because banks borrow short term to fund long-term loans, this reduces profits on future lending. TLTROs do no such thing.

This isn’t the first time the ECB extended cheap funding to banks. The original version was 2011’s longer-term refinancing operation (LTRO), which didn’t require banks to lend the funds. Amid a debt crisis and recession, banks scrambling for liquidity borrowed over €1 trillion in three-year LTRO funds.^[i] When LTRO repayment approached in 2014, we saw many in media fearing this would squelch lending. Hence, the ECB introduced the first TLTRO with four-year maturities, allowing banks to roll over their LTRO funds, providing they used them to underpin lending. Banks took €430 billion.^[ii] In 2016, the ECB launched TLTRO-II—another four-year facility—which permitted greater borrowing at lower rates for new private sector loans. Banks not only rolled over most of their TLTRO-I funding, they increased it to €739 billion.^[iii] Repayments for TLTRO-II are now poised to start coming due in the next 12 – 18 months. The ECB’s announcement it will offer two-year funding should allow banks to roll over funding once again, if they choose to.

Since last year, financial publications we review have raised concerns over TLTRO-II’s wind down—thinking “financing cliffs for banks” await. Many articles we have read argue banks repaying the ECB will lack sufficient funding to extend loans, sapping eurozone loan growth. But we think this is a stretch. Whilst there are select exceptions, banks are, for the most part, amply funded in Europe, in our view. TLTRO funding may be marginally cheaper than deposits, borrowing from other banks or tapping the ECB’s permanent, short-term lending facilities, but it isn’t as if banks have no means to fund new loans. Moreover, banks have been voluntarily repaying their TLTRO loans early with total balances declining since 2017^[iv]—overall eurozone lending hasn’t suffered. Hence, to the extent TLTRO-III is about allowing banks to roll over existing borrowings, we think the ECB’s move targets a false fear.

In our view, the ECB’s recent TLTRO-III announcement—with quarterly auctions starting in September—shouldn’t hurt, but it shouldn’t be stimulate much activity, either. If the ECB hadn’t re-upped TLTROs, we doubt markets would have rippled much. As it stands, we think it probably just extends the status quo a couple more years, helping some banks with tighter deposit funding roll over previous TLTRO-II loans. But in our analysis, most large eurozone banks have no such issues. Meanwhile, credit looks to be circulating fine in the eurozone, supporting private sector growth.^[v]

To us, markets’ initial negative reaction to the ECB’s move seems inspired, in part, by some worrying the ECB sees weakness ahead. But central bankers have no unique insights into the economy, in our view, which a long global history of monetary errors attests to.  Ironically, the same day the ECB announced TLTRO-III, revised eurozone Q4 GDP data showed inventory adjustment drove the slowdown—more evidence weakness is likely a one-off.^[vi] GDP’s calculations treat rising inventories as a plus and falling a minus to headline GDP. Yet falling inventories can require restocking in future quarters, providing demand remains sufficient. In this way, the drag can be seen as a possible forward-looking positive for economic activity. Nevertheless, the ECB lowered its 2019 eurozone GDP growth forecast to 1.1% from 1.7% a few months ago.^[vii] Perhaps that holds up, perhaps not. But we are sceptical.

The economic outlook remains bright to us. The eurozone’s yield curve is positively sloped, which we think incentivises private sector loan growth, regardless of TLTROs. Plus, the latest purchasing managers’ indexes (PMIs)—surveys of businesses measuring the breadth of growth—and PMI new orders subindexes indicate Q4 weakness was likely temporary. The eurozone’s composite PMI—combining manufacturing and services—rose to 51.9 in February, led by the services sector, the largest slice of eurozone GDP by industry.^[viii] Levels above 50 signal expansion. Moreover, services new orders also indicated broadening growth—which should help keep the economy chugging along in 2019.^[ix] That so many take a dim view despite the evidence suggests weakness is overstated. Forward-looking markets move most on the gap between reality and expectations, in our view, and dour expectations seemingly provide a low hurdle for reality to clear. As reality dawns, revealing people’s worst fears unwarranted, we think markets should rally.

^[i] Source: ECB, as of 13/3/2019. History of all ECB open market operations, three-year fixed rate longer-term refinancing operations allotted on 21/12/2011 and 29/2/2012.

^[ii] “Update on Economic and Monetary Developments,” ECB Economic Bulletin, 11/5/2017.

^[iii] Ibid.

^[iv] Source: ECB, as of 14/3/2019. Summary of ad hoc communication related to monetary policy implementation issued by the ECB, targeted longer-term refinancing operation voluntary repayments since 29/3/2017.

^[v] Source: ECB, as of 27/2/2019. Statement based on adjusted loans to the private sector, March 2017 – January 2019.

^[vi] “GDP Main Aggregates and Employment Estimates for Fourth Quarter 2018,” Eurostat, 7/3/2019. GDP is gross domestic product, a government-produced estimate of economic activity.

^[vii] “Press Conference,” President Mario Draghi, ECB, 7/3/2019.

^[viii] Source: IHS Markit, as of 5/3/2019.

^[ix] Ibid.