Search This Blog

Wednesday 11 June 2014

The deflationary trend in the Euro-zone in charts: my reaction to the statement of chairman Mario Draghi of the ECB AND to the column of Mathijs Bouman in Het Financieele Dagblad.

Friend and foe of the chairman of the European Central Bank (ECB) agreed that Mario Draghi finally deployed his ‘bazooka” during his 5 June statement on behalf of the ECB:

Draghi: First, we decided to lower the interest rate on the main refinancing operations of the Eurosystem by 10 basis points to 0.15% and the rate on the marginal lending facility by 35 basis points to 0.40%. The rate on the deposit facility was lowered by 10 basis points to -0.10%. These changes will come into effect on 11 June 2014. The negative rate will also apply to reserve holdings in excess of the minimum reserve requirements and certain other deposits held with the Eurosystem.

Second, in order to support bank lending to households and non-financial corporations, excluding loans to households for house purchase, we will be conducting a series of targeted longer-term refinancing operations (TLTROs). Counterparties will be entitled to borrow, initially, 7% of the total amount of their loans to the euro area non-financial private sector…

In addition, from March 2015 to June 2016, all counterparties will be able to borrow, quarterly, up to three times the amount of their net lending to the euro area non-financial private sector, excluding loans to households for house purchase, over a specific period in excess of a specified benchmark. Net lending will be measured in terms of new loans minus redemptions. Loan sales, securitisations and write-downs do not affect the net lending measure. The interest rate on the TLTROs will be fixed over the life of each operation, at the rate on the Eurosystem’s main refinancing operations (MROs) prevailing at the time of take-up, plus a fixed spread of 10 basis points. A number of provisions will aim to ensure that the funds support the real economy.

Third, the Governing Council decided to intensify preparatory work related to outright purchases in the ABS [asset backed securities – EL] market to enhance the functioning of the monetary policy transmission mechanism. Under this initiative, the Eurosystem will consider purchasing simple and transparent asset-backed securities with underlying assets consisting of claims against the euro area non-financial private sector

Fourth, in line with our forward guidance and our determination to maintain a high degree of monetary accommodation, as well as to contain volatility in money markets, we decided to continue conducting the MROs [main refinancing operations – EL] as fixed rate tender procedures with full allotment for as long as necessary, and at least until the end of the reserve maintenance period ending in December 2016.

Furthermore, we decided to conduct the three-month longer-term refinancing operations (LTROs) to be allotted before the end of the reserve maintenance period ending in December 2016 as fixed rate tender procedures with full allotment. The rates in these three-month operations will be fixed at the average rate of the MROs over the life of the respective LTRO. 

Turning to the monetary analysis, data for April 2014 continue to point to subdued underlying growth in broad money (M3). Annual growth in M3 moderated further to 0.8% in April, from 1.0% in March. The growth of the narrow monetary aggregate M1 moderated to 5.2 % in April, after 5.6% in March. In the recent past, the increase in the MFI net external asset position, reflecting in part the continued interest of international investors in euro area assets, has been the main factor supporting annual M3 growth.

Chart of the M1 and M3 money supply in the Euro-zone
Chart by: Ernst's Economy for You
Data courtesy of: ECB
Click to enlarge
Draghi: The annual rate of change of loans to non-financial corporations (adjusted for loan sales and securitisation) was -2.7% in April 2014, compared with -3.1% in March. Weak loan dynamics for non-financial corporations continue to reflect their lagged relationship with the business cycle, credit risk and the ongoing adjustment of financial and non-financial sector balance sheets. The annual growth rate of loans to households (adjusted for loan sales and securitisation) was 0.4% in April 2014, broadly unchanged since the beginning of 2013.

Loans supplied by Credit Institutions in the Euro-zone in Millions of Euros
Chart by: Ernst's Economy for You
Data courtesy of: ECB
Click to enlarge
There is almost no arguing that the Euro-zone seems at the brink of prolonged (?) deflationary times.

First, one should consider that the Euro-zone has expanded with no less than five countries, since January 2008: Cyprus, Malta, Slovakia, Estonia and Latvia. 

With that in mind, one only has to look at both aforementioned charts, to see that the available broad money supply 'M3' and the outstanding credit from credit institutions in fact have tightened in the Euro-zone, during the last few years. Especially the loans supplied by Credit Institutions have plummeted since the second quarter of 2012.

The fact that a substantial expansion took place within the Euro-zone can hardly be recognized in the aforementioned charts. This is a tell-tale signal of the ongoing deflationary impulses, in my humble opinion.

As Draghi probably agreed with these impressions, he pulled his bazooka out of the closet… Summarizing, this ‘bazooka’ consists of four different measures:
  • Lowering the refi-rate by another 0.1% and penalizing excess bank deposits at the ECB with a negative interest rate of -/- 0.1% (First measure);
  • Deploying new, massive lending facilities for households and non-financial corporations (Second measure);
  • Supplying the banks with money against “plain-bread-and-butter collateral” (Third measure);
  • Making sure that this money can be borrowed for a prolonged time at extremely favourable rates (Fourth measure).  

You can argue about the answers to the questions, whether these four measures are sensible or not AND whether these measures will have the desired effects of:
  • a. increasing the money flow from the banks to private households and Small and Medium Enterprises (SME); 
  • b. rising the inflation rate in the Euro-zone after all.

Personally, I am not convinced that these measures by Mario Draghi will actually have these desired effects. 

Lending to SME company is still a risky and even unprofitable business for many banks, in spite of the considerable spreads between the funding costs of loans and the actual interest rates, charged to the customer. 


Many factors determine the customers that a bank lends to within the scope of its balance sheet, including the nature and duration of the relationship with the customer, the risk profile of the proposed loan, the price the bank receives for taking on risk, the extent to which the loan contributes to the creation of concentration risk on the balance sheet and the requirements of the sustainability policy being pursued.

The importance of proceeding carefully in this respect, is underlined by recent experiences with lending to SMEs. Dutch SMEs made up 5% of ING’s total credit portfolio in 2013 but contributed 22% of the total addition to the reserve for loan losses.

Against this background, the question is what actual public interest is served by loosening credit standards applied to SMEs? And how does this relate to the aim of safer banks? In fact, banks are now being told to stretch their approval criteria, which is the same as calling for more financing (often of losses) and expansion instead of reducing SMEs’ dependence on debt.

While Mario Draghi’s measures will definitely reduce the funding costs for banks, which are lending to SME companies, these measures will not reduce the risks involved in such loans.

The reason for this is, that the lender's risk is mainly positioned at the demand-side of these SME businesses: most problems for SME companies and (especially) retailers are caused by the ubiquitous consumer strike, which is still ongoing at the moment. 

From my own experience at the Business Lending department of a Dutch multinational bank, I know that it was mainly the risk component, which made SME lending an unprofitable business during the last few years. Not the funding costs or the narrow interest spread of such a loan...


Nevertheless, the one thing that you hardly couldn’t argue about in the prelude to last week’s statement, was Mario Draghi’s unspoken obligation ‘to do something’! 

Draghi had to act, in order to show the world that he meant business, with his battle against especially the looming risk of deflation and – more generally – the prolonged economic crisis in the Euro-zone. 

In the past months, Draghi had so often announced that he would act decisively when the inflation rate would keep on dropping, that the whole financial world – and Draghi himself – felt that the ECB would lose all credibility, had Draghi again stuck with ‘words and warnings’ in June.

And now Draghi’s bazooka should force the banks to lend more money at especially private households and  SME companies – almost at-gunpoint. 

Draghi hopes (probably against his better judgment ) that these measures will be effective, where previous measures with respect to the interest rates and the money supply all failed, for the reasons earlier described by Wilfred Nagel of ING Bank.

With the following charts, based on data from Eurostat, I will show that the risk of deflation in the Euro-zone is not an imaginary risk, but a very vivid one. 

The inflation trend is definitely pointed downwards for almost all categories of household and corporate spending:

Inflation in the Euro-zone from 2011 - 2014
Category: Food
Chart by: Ernst's Economy for You
Data courtesy of Eurostat
Click to enlarge
Inflation in the Euro-zone from 2011 - 2014
Category: Non-alcoholic Beverages
Chart by: Ernst's Economy for You
Data courtesy of Eurostat
Click to enlarge
Inflation in the Euro-zone from 2011 - 2014
Category: Clothing and Footwear
Chart by: Ernst's Economy for You
Data courtesy of Eurostat
Click to enlarge

Inflation in the Euro-zone from 2011 - 2014
Category: Transport
Chart by: Ernst's Economy for You
Data courtesy of Eurostat
Click to enlarge

Inflation in the Euro-zone from 2011 - 2014
Category: Education
Chart by: Ernst's Economy for You
Data courtesy of Eurostat
Click to enlarge

Inflation in the Euro-zone from 2011 - 2014
Category: Communication
Chart by: Ernst's Economy for You
Data courtesy of Eurostat
Click to enlarge

Inflation in the Euro-zone from 2011 - 2014
Category: Furnishing, household equipment
and routine maintenance
Chart by: Ernst's Economy for You
Data courtesy of Eurostat
Click to enlarge

Inflation in the Euro-zone from 2011 - 2014
Category: Health
Chart by: Ernst's Economy for You
Data courtesy of Eurostat
Click to enlarge

Inflation in the Euro-zone from 2011 - 2014
Category: Housing, water, electricity, gas and other fuels
Chart by: Ernst's Economy for You
Data courtesy of Eurostat
Click to enlarge

Inflation in the Euro-zone from 2011 - 2014
Category: Miscellaneous Goods
Chart by: Ernst's Economy for You
Data courtesy of Eurostat
Click to enlarge

Inflation in the Euro-zone from 2011 - 2014
Category: Recreation and Culture
Chart by: Ernst's Economy for You
Data courtesy of Eurostat
Click to enlarge

Inflation in the Euro-zone from 2011 - 2014
Category: Restaurants and Hotels
Chart by: Ernst's Economy for You
Data courtesy of Eurostat
Click to enlarge
Last Saturday, the well-known Dutch economist and columnist Mathijs Bouman wrote a thought-provoking column about Draghi’s bazooka. 

Bouman argued that Draghi had not been fighting against the phenomena ‘deflation’ last Thursday, but against the high interest rates that banks charge to their customers (for the reasons I described earlier in this article). 

He might actually have a point there…

Nevertheless, concerning the high interest rates that banks charge to their customers, I stated earlier that banks are forced too do so and not simply overcharge customers at will. Banks have no other option then to cover their substantial losses on SME loans gone awry. However, Bouman does not take this into consideration at all in his column.

Besides that, in this column Mathijs Bouman tried to downplay the risk of deflation with a simplified example.

Here are the pertinent snippets of this column:

Nobody postpones his purchases, as a consequence of a dropping general price level – which is what we talk about with the expression ‘deflation’. 

This is actually useless. Think of this: "I don’t buy green beans, as they will be cheaper tomorrow. Tomorrow I won’t buy them again, as the price will drop further again the next day. In the end, I will never buy green beans anymore. And as my shopping cart will become cheaper every day, I will never buy something anymore". 

Whoever speculates on price drops for eternity, will die of starvation.

Although I sympathize with Bouman’s argument, I personally think that he mixes up cause and effect in his column.

People will not consume less (effect), due to deflation (cause)… Instead, deflation (effect) will continue, because people consume less for a prolonged period of time (cause)! 

And of course this is not so much true for necessary, daily consumption goods and foodstuffs, like greenbeans or bread, as people need to eat after all: this makes Bouman’s example so ridiculous and over-the-top.

However, I am certain that in recent years there has been a clear shift from more expensive foodstuffs and daily consumption goods, towards cheaper food and articles. This shift will definitely have caused deflationary impulses. It is not a coincidence that discount supermarkets, like Lidl and Aldi have been the absolute winners of this crisis, at the expense of the more expensive supermarket chains!

Besides that, this shift did also take place in the general consumption of luxury goods and durable household appliances: 

People still buy these goods – when they need them or really want them -, but they buy them only at the lowest possible price. And when such purchases can be avoided, they will be skipped at this very moment. 

This is the reason that many chains for household appliances and small electronics have perished, during the last few years, while the remaining chains are involved in an enduring race-to-the-bottom for prices. Draghi's bazooka won't help this effect.


And the worst danger of deflation is – in my humble opinion – that it can lead to an enduring, negative wage/ price spiral and restrained consumption for many years. 

Many companies cannot afford to pay higher wages to their personnel at this very moment and the companies that can afford it, simply don’t do that…

No comments:

Post a Comment

Blogoria.de

Blogarchief