ECB QE could blow up a ‘credit bubble’ in the eurozone

The European Central Bank’s long-awaited quantitative easing (QE) programme will not actually do much to lift the eurozone from economic stagnation and deflation, a strategist warned.

QE—under which the ECB would buy bonds issued by governments in the eurozone to try to stimulate the economy – will increase risk taking in financial markets but would not stimulate the real economy without fiscal measures, Alberto Gallo, head of European macro credit research at RBS, said in a presentation on Thursday.

The ECB’s monetary policy meetings will take place less frequently this year, with the first one scheduled for January 22.

Gallo said a decision by the ECB to carry out quantitative easing would be positive in the short term, but gloom is likely to return to the markets for the longer term.

“We are all becoming traders. We are all focused short term. We’re all ok with the short-term situation, because we know the ECB will do QE. My concern is that we can make a good trade out of Europe, but not a good investment,” he said.

The fact that QE worked in the US is not a guarantee that it would work in the eurozone. For one, the US had much deeper capital markets, which could take the loss.

ECB QE and bad loans

ECB QE may not work as well as the Fed’s because of bad loans. Source: RBS

Another issue is that in the US non-performing loans increased at a much slower pace than in the eurozone during the crisis.

“We’re all trying to reduce interest costs and delay the problem, but nobody is addressing the problem of the overhang of debt,” Gallo said.

“In other words we are reducing the problem by reducing interest payments but we don’t care about the principal (for debt).

We don’t know what’s going to happen in Italy, for instance, if there is a recession three years down the line. There is a line between liquidity and solvency, and Greece is already on the other side of that line,” he warned.

ECB QE Transmission Problems

Over the short term, investors in the eurozone have reasons to be optimistic because a big investor will come into the markets and buy bonds.

But over the long term, how will the ECB’s QE actually be transmitted to the real economy?

One channel will be that of the depreciated euro, which would stimulate exports and make imports more expensive. This will raise inflation, reducing the debt burden.

Another channel should be that of bank lending. As banks cannot invest in sovereign bonds because the supply diminishes, and with interest rates going lower, they should go out and lend to the real economy. At least, that’s what should happen in theory.

In practice, Gallo explained, European banks were not necessarily created to serve monetary policy transmission too well. In many countries, banks had been created with social purposes such as lending to local businesses on favourable terms in mind, and backed by implicit government guarantees.

Now those guarantees are no longer there, because governments do not have the money to bail out banks that get into trouble. So banks need to earn their way out of the crisis, at a time when tightening regulation increases their costs of lending. This is a big part of why credit growth is still anaemic in the eurozone.

The single currency area should close down the weak banks and even halve the number of branches in some countries – Gallo noted that in Italy, for instance, there are more branches per thousand inhabitants than there are pharmacies.

There is already stiffer competition for banks, which have to face the advance of the digital payments and crowdfunding. Some analysts believe that this could spark the next big crisis for European banks.

Of course, not everything is bad. The falling price of oil is likely to stimulate consumption in the eurozone, while it is highly unlikely that Greece will actually leave the single currency as some analysts fear.

But the issue of credit risk remains.

“When people worry about interest, not principal, that is a sign of a credit bubble brewing,” Gallo warned.


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