Easy money: Will the ECB have no choice but to be a copycat of the US?

In July 2012, Mario Draghi, president of the European Central Bank (ECB) had said that “the ECB is ready to do whatever it takes to preserve the euro. And believe me, it will be enough.”

Yesterday, the ECB cut its deposit rate to - 0.1 percent. European banks need to maintain a certain portion of their deposits with the ECB as a reserve. This is a regulatory requirement. But banks maintain excess reserves with the ECB, over and above the regulatory requirement. This is because they do not see enough profitable lending opportunities.

In April 2014, the European banks had excess reserves amounting to 91.6 billion. This was over and above the reserve of 103.6 billion that they needed to maintain as per regulatory requirement. The ECB currently pays no interest on the excess reserves of banks. With effect from June 11, 2014, it will pay an interest of - 0.1 percent on the excess reserves. What this means is that the ECB will charge the banks for any excess reserve that they maintain with it.

More from International

Nato on alert as Poland scrambles jets amid Russian drone threat Hong Kong rejects bid to recognise same-sex partnerships — a first for govt bill since China takeover

This has been done to ensure that the banks do not maintain any excess reserves with the ECB and go out and lend that money instead. The lending to the private sector in Europe has been declining at the rate of 1.8 percent. Over and above this, the economic growth in the Eurozone (18 countries in Europe which use Euro as their currency) has been very slow.

During the period of January to March 2014, the economic growth was at a minuscule 0.2 percent. The Eurozone managed to avoid an economic contraction primarily due to a strong performance by the German economy.

Impact Shorts

More Shorts

What will FBI’s new office in New Zealand do? Kash Patel’s suggestion leaves China fuming

What this means is that economies of certain countries in Europe are contracting. Economies of Italy, Holland and Portugal contracted during January-March 2014. The economy of France did not grow at all. What makes the situation worse is the latest inflation number. In May 2014, the inflation in the Euro Zone fell to 0.5 percent. It was at 0.7 percent in April 2014. This is well below the ECB’s target inflation of 2 percent.

If inflation keeps falling, the Eurozone will soon be experiencing a deflationary scenario in which prices will keep falling. In such a scenario people will postpone consumption in the hope of getting a better deal in the days to come. And this will further impact economic growth.

Due to these factors the Draghi-led ECB has decided to cut the deposit rate to - 0.1 percent. The hope is that banks will withdraw their excess reserves from the ECB and lend that money. But how good are the chances of something like that happening? The ECB had cut the interest rate on excess deposits to zero percent in July 2012. Its been around two years since then and as mentioned earlier the lending to the private sector in Europe has been going down at the rate of 1.8 percent.

Also, banks always have the option of maintaining their excess reserves in their own vaults rather than depositing it with the ECB. They can always exercise that option and still not lend. Interestingly, in July 2012, the central bank of Denmark had taken interest rates into the negative territory. The lending by Danish banks fell after this move. Banks will go slow on lending unless they feel that their lending will turn out to be profitable. And that is something the ECB or for that matter any central bank, cannot do much about.

So, that brings us back to the question of why did the ECB take interest rates into the negative territory? The only possible answer seems to be that ECB wants to weaken the euro against other currencies. The euro has appreciated against the yen since October 2012. In October 2012, one euro was worth around 100 yen. Currently, one euro is worth around 140 yen. This has happened because of the massive money printing carried out by by the Bank of Japan, the Japanese central bank, since early 2013.

Germany is the export powerhouse of Europe and competes directly with Japan in many hi-tech sectors. Nevertheless, despite the euro appreciating against the yen, the Eurozone as a whole has been running a trade surplus i.e. its exports have been greater than its imports.

In February 2013, the Eurozone ran a trade surplus of 13.6 billion. This is primarily because a collapse in demand in many Eurozone countries has led to a significant cut down in imports. Also, with a collapse in internal demand businesses have been forced to look for external growth.

Now with the ECB looking to cheapen the euro, it will lead to German exports becoming more competitive than they were in the past and this in turn will push up the trade surplus of the Eurozone further. Whether this will benefit countries in the Eurozone other than Germany, remains to be seen.

In a press conference yesterday, Mario Draghi said “We think this is a significant package…Are we finished? The answer is no. If required, we will act swiftly with further monetary policy easing. The Governing Council is unanimous in its commitment to using unconventional instruments within its mandate should it become necessary to further address risks of prolonged low inflation.”

Speculation is rife that the Draghi-led ECB will soon enter the full blown quantitative easing territory and print money to buy bonds, something that the Federal Reserve of the United States and the Bank of Japan have been doing for a while now.

But it may not be so easy to initiate quantitative easing in the Eurozone, given that 18 countries of the Eurozone will have to support the decision. But as Guntram B. Wolff, director of Bruegel, a research organization in Brussels told The New York Times,“The conventional measures are all done…What remains is quantitative easing.”

In short, the era of “easy money” will continue.

The author can be reached at vivek.kaul@gmail.com