ECB Rate Cut~ Necessary to maintain market sentiment, but actual effects are limited

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VOL 7, NO 1 July 6, 12 ECB Rate Cut~ Necessary to maintain market sentiment, but actual effects are limited Summary The European Central Bank (ECB) decided to cut the main refinancing rate from 1.

1 VOL 7, NO 1 July 6, 12 ECB Rate Cut~ Necessary to maintain market sentiment, but actual effects are limited Summary The European Central Bank (ECB) decided to cut the main refinancing rate from 1.% to its lowest-ever.75% on July 5. This change is the first since December 11. The ECB also cut the deposit facility rate to.%, also a first since the establishment of the ECB. Only the rate cuts were decided at this meeting, and introducing another long-term refinancing operation (LTRO), or purchasing sovereign bonds of Spain and Italy were not even discussed. ECB President Draghi identified 1) downside risks to growth have materialized, 2) inflationary pressure has been dampened, and 3) policies committed by EU leaders at the Eurozone summit late last month, as main reasons for the rate cut. Speculation for the rate cut had rapidly increased since the market had seen several weak data regarding the real economy, and especially after the agreement reached at the Eurozone summit, and some quotes indicating this rate cut by ECB members. This decision to cut rates was needed precisely at this timing in order to maintain the markets sentiment. By lowering the refinancing rate, the cost of funding for private banks will slightly improve. On the other hand, by introducing zero deposit rate, the funds which private banks had originally deposited to the ECB could be encouraged to flow to bank lending. However, this is unlikely since the demands by enterprises are weak. President Draghi revealed that the decisions made by the ECB were unanimous by all means and that this should show strength in the decision. The ECB did cut rates by just 25bps for now, but it is expected that the ECB will encourage its member states to take additional measures, and meanwhile consider the precise timing of further rate cuts or other non-standard measures that were saved until necessary. 1

2 1. Decisions by the ECB and the reasons behind them On July 5, the ECB decided to cut the main refinancing rate from 1.% to its lowest-ever.75%. This change is the first since December 11. The ECB also cut the deposit facility rate to.%, also a first since the establishment of the ECB. Only the rate cuts were decided at this meeting, and addition of another long-term refinancing operation (LTRO), or purchasing sovereign bonds of Spain and Italy that were speculated partially, were not even discussed. However, President Draghi did remind us of the decision taken by the Governing Council on June 22 concerning further measures to increase collateral availability for counterparties. Monetary policy decisions 1. Interest rate on main refinancing operations 1.%.75% 2. Interest rate on marginal lending facility 1.75% 1.5% 3. Interest rate on deposit facility.25%.% (All decisions with effect from 11 July 12) Figure 1:Main Interest Rates (%) Marginal lending facility Main refinancing operations (fixed rate) 3-month EURIBOR EONIA (overnight rate) Deposit facility Source: Compiled by BTMU ERO based on Bloomberg (Year/Month) President Draghi identified 1) downside risks to the euro area growth have materialized, 2) inflationary pressure are broadly balanced, and 3) policies committed by EU leaders at the Eurozone summit late last month, as main reasons for the rate cut. President Draghi had mentioned in his press conference last month, that there were several members that voted for a rate cut, while he himself stated the effects of a rate 2

3 cut should be limited, as market functions are deteriorating. Therefore, only a few had expected the ECB to cut rates this month. However, in the middle of June, several weak data such as business sentiment were released in the Eurozone, and this was also the case for growth driver Germany. The Eurozone unemployment also reached an all-time high of 11.1% in May. On the other hand, German inflation (CPI) had dropped to 1.7% (below ECB target of close but below 2% ), and inflation for Eurozone was unchanged from last month at 2.4%. Some ECB members quoted, the ECB will consider cutting policy rates at the July meeting and there is no rule that 1.% policy rate is the lower limit. The markets speculations on ECB rate cuts were heightened especially after the Eurozone summit at the end of last month, where integration of bank supervision, capital injection to banks from ESM, and financial aid for Spain were agreed upon. Had the ECB not cut the rates at all at its July meeting, there were high chances of drastic disappointment in the market sentiment, and thus the decision was needed precisely at this timing. Figure 2:German Real GDP and PMI Figure 3:Eurozone Inflation 2. (q/q,%) (Index) 7 5. (y/y contribution ratio, %) Germany Real GDP Germany PMI Manufacturing (RHS) Growth Contraction Energy Food, tobacco Core Core inflation rate HICP Total ECB target below 2% Source: Compiled by BTMU ERO based on Eurostat and Bloomberg 25 (Year) (Year) Source: Compiled by BTMU ERO based on Eurostat 2. The Effects of the Rate Cut By lowering the refinancing rate, the cost of funding for private banks will slightly improve. Since the rates for funds received by the twin LTROs last December and in February will be the average of the main refinancing rate during the period borrowed, the burden on private banks will be lighter. On the other hand, by introducing zero deposit rate, the funds which private banks had originally deposited to the ECB could be encouraged to flow to bank lending. However, whether bank lending will be 3

4 enhanced or not will depend very much on demand. The April ECB Bank Lending Survey showed that demands plunged especially for capital expenditures. Although both short-term and long-term funds demand were projected to have been recovering recently, actual data for May showed that lending to the private sector was -.2%, the first decrease since March 1. Since the demands are weak, we cannot expect much from the zero deposit rate. Figure 4:Corporate Funds Demand (Increased - Decreased) SMEs Large companies Actual 4 3 Projection Short-term Long-term Source: Compiled by BTMU ERO based on ECB (y/y, %) Figure 5:Bank Lending to Private Sector Italy France Eurozone Germany Spain Source: Compiled by BTMU ERO based on ECB (Year) 3. Markets Reactions Regarding foreign exchange rates, the Euro fell from 1.25 USD to 1.23 USD after the rate cut announcement. Stock prices initially rose after the announcement, but since there were no other measures besides the rate cut, and President Draghi continued to express pessimistic concern for downside risks on the economy, the rise was temporary and hence fell. The long-term interest rates for peripheral countries rose, as there was no indication on restarting bond purchases. The Spanish 1 year yields rose from 6.4% to 6.8%, and Italy, from 5.8% to almost 6%.. 4

5 (USD/EUR) Figure 6:Euro Exchange Rates against JPY (RHS) against USD (JPY/EUR) 15 11/1 11/4 11/7 11/1 12/1 12/4 12/7 (Year/ month) Source: Compiled by BTMU ERO based on Bloomberg Figure 7:German Sovereign Spreads (%) (bil euro) 25 ECB weekly bond purchase (RHS) Italy(BBB+ ) Spain(Baa3 ) 11/1 11/4 11/7 11/1 12/1 12/4 12/7 NB: Ratings are the lowest of the three major rating agencies. (Year/Month) The arrow indicates negative outlook. Source: Compiled by BTMU ERO based on Bloomberg 4. What s next for ECB? President Draghi revealed that the decisions made by the ECB were unanimous by all means and that this should show strength in the decision. When asked how bad the current situation is, he answered that the global economy is definitely not at the level of the global crisis during 8~9, because real GDP growth rates are hovering at around zero percent, as opposed to their falling much further during the global crisis. ECB still expects the Eurozone economy to recover gradually towards the end of the year with overall improvement in sentiment and stabilization of external demand as its main growth drivers. On the other hand, President Draghi reiterated his concern for downside risks on the economy. Steps towards the sovereign crisis must still be taken for several years. Agreement reached at the EU summit last month needs to be put in place and its progress must be monitored closely. The ECB only cut rates by just 25bps for now, but it is expected that the ECB will encourage its member states to take additional measures, and meanwhile consider the precise timing of further rate cuts or other non-standard measures that were saved until necessary. Masayo Taiko (masayo_taiko@mufg.jp) The Bank of Tokyo-Mitsubishi UFJ, Ltd. Economic Research Office 2-7-1, Marunouchi, Chiyoda-ku, Tokyo , Japan 5

6 This report is intended only for information purposes and shall not be construed as solicitation to take any action such as purchasing/selling/investing financial market products. In taking any action, each reader is requested to act on the basis of his or her own judgment. This report is based on information believed to be reliable, but we do not guarantee its accuracy. The contents of the report may be revised without advance notice. Also, this report is a literary work protected by the copyright act. No part of this report may be reproduced in any form without express statement of its source. 6

Main Economic & Financial Indicators Eurozone

Main Economic & Financial Indicators Eurozone 06 NOVEMBER 2014 AKIKO DARVELL ASSOCIATE ECONOMIST ECONOMIC RESEARCH OFFICE (LONDON) T +44(0)2075771591 E akiko.darvell@uk.mufg.jp The Bank of TokyoMitsubishi