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Blocked monetary transmission to squeeze Eurozone credit, S&P’s economist says

Dubai: Credit growth in the Eurozone remains tight as loan expansion remains curtailed and this could result in the slowing consumer price inflation morphing into deflation, Jean-Michel Six, the Paris-based chief economist of Standard & Poor’s (S&P) for Europe, the Middle East and Africa told Gulf News in a recent interview.

“Despite accommodative monetary policy and abundant liquidity, monetary transmission mechanisms are blocked in the Eurozone and thus the credit channels remain constrained,” Six said.

There are two things happening in the Eurozone. On the one hand the European Central Bank (ECB) backs banking sector liquidity with the full allotment policy which allows banks to borrow on a day-to-day basis as much as they want. On the other hand, the ECB’s asset quality review (AQR), as part of its comprehensive assessment of Eurozone banks in 2014 is going to apply pressure on banks to keep their balance sheets clean and adequately capitalised.

The AQR is going to be a very important review that is going to be conducted by the ECB and the European Banking Authority scrutinising the balance sheets of about 130 large European banks to check their health and to see if they are sufficiently capitalised. “Unavoidably the banks have been preparing for the AQR. They want to be seen as strong and they have been restructuring and repairing their balance sheets and in particular they have been deleveraging aggressively. Banks — deleveraging of European banks represented 25 per cent of their accumulated balance sheets in just 18 months. This is a major diet they have been gong through,” Six said.

The S&P economist has warned that slow credit growth could further slow down consumer price inflation which could eventually morph into deflation, especially if the euro remains strong and commodity prices ease further.

“Deflation is a self-fulfilling spiral, as companies and consumers would tend to postpone purchases and consumption in the belief that prices will decline in the future. If the credit dries up further, it would certainly hit spending,” he said.

The ECB’s latest interest rate cut to a nominal 0.25 per cent might help ease funding costs for banks in the periphery, but it is unclear whether it will result in new lending to households and the private sector. That’s because the lack of monetary transmission has more to do with banks’ weak balance sheets and Europe’s low growth potential.

The AQR is clearly contra-cyclical. The S&P economist says that the ECB needs to be even more accommodative in order to offset the impact AQR on liquidity and lending. As the interest rate that banks receive on their deposits is already at zero, a further ECB cut could put that into negative territory. This shows that in and of itself, the interest rate policy tool may have reached its natural limit. However Six says negative deposit rates could ease lending and the euro’s relative strength.

“Certainly negative deposit rates will provide a bit of help in reducing the strength of the euro which could be of help to economies to recover, especially the export sector,” Six said.

Going forward, Six said, the ECB could adopt more unconventional measures to stimulate financial conditions, for instance, by buying corporate loans from banks to stimulate credit growth.

“There are discussions on buying assets that is ECB buying pools of loans directly from banks. But unlike in the US, the securitisation market in Europe is very small. The intention is good to buy ABS and keep them on ECB’s balance sheet,” he said.