ECB ‘saves’ banks as economies sink

Stock markets generally like to party in January. Last month’s celebration was particularly ebullient. Having been in freefall for much of last year, Europe’s stock markets enjoyed their best January since 1998. The master of ceremonies was Mario Draghi, the recently installed head of the European Central Bank. The ECB’s decision in early December to provide almost limitless funds to the European banking system brought 2011’s financial dance macabre to an abrupt halt. While liquidity concerns have abated, Europe’s solvency crisis is far from over.

Last year, a nasty feedback loop opened up as rising sovereign default risk in Italy and Spain fuelled concerns about the asset quality of European banks. Depositors started to become restive. Falling stock prices and rising credit spreads caused difficulties. The interbank loan market froze over. As the panic endured, Europe’s banks were forced to shrink their assets.

This was a very dangerous state of affairs which, had it continued unchecked, might well have led to major bank failures. In early December, however, the ECB announced it would extend the length of its funding to European banks to three years. Banks immediately applied for nearly €500bn from the Long-Term Refinancing Operation (LTRO). A second LTRO, which many expect to be twice as large, will be launched by the ECB at the end of this month.

Over the past couple of months, the cost of Italian two-year debt has fallen from 7 per cent to around 3 per cent. As investors’ fears abated, the share prices of European banks rebounded. The vicious cycle that gripped Europe’s financial system appears to have ground to a halt. Before investors get too complacent, they should consider what the LTRO is likely to achieve.

First, the good news. Unlimited access to ECB money means Europe’s banks will have cash on hand to repay any loans that become due this year. Since deposit outflows can quickly be replaced with ECB funds, the periphery is less vulnerable to bank runs. Now that the liability side of their balance sheets has stabilised, European banks will not be in such a rush to dispose of assets.

At around 1 per cent, LTRO money is also very cheap. Barclays estimates that lower funding costs will boost the earnings of eurozone banks by 4 per cent. Clever bankers may do even better – Italy’s Unicredit, for instance, is using money from the ECB to repurchase its own hybrid bonds at a large discount. Increased profits reduce the amount of equity capital that the banks will need to raise. More stable share prices diminish the risk of dilution for bank shareholders.

Although the ECB is not allowed to buy sovereign bonds at the moment of issue, there is nothing to stop European banks from acquiring government bonds and handing them over to the central bank as collateral for a loan. Spanish banks increased their holdings of government bonds by €27bn in December. This has reversed a recent trend for banks to offload the sovereign bonds of the European periphery.

Mr Draghi’s largesse, however, cannot cure all of Europe’s woes. Within the eurozone, banks have becomes increasingly reluctant to lend across borders. Banks in the core of Europe are reportedly still looking to reduce exposure to the more spendthrift members of the currency union. On its own the LTRO is unlikely to reverse this financial Balkanisation. European banks remain massively leveraged. They will continue to shrink their balance sheets, albeit at a more measured pace.

Nor can a wave of Mr Draghi’s monetary wand remove the eurozone’s macroeconomic imbalances. Much of the periphery remains uncompetitive relative to Germany. Ireland, which has slashed its unit labour costs by 15 per cent since 2008, remains a standout in this respect. New governments in Spain and Italy have announced economic reforms but any gains will take a while to come through. Meanwhile, Europe’s periphery continues to run large current account deficits. The combined current account deficits of Portugal, Italy, Greece and Spain in 2011 is estimated at €129bn by the International Monetary Fund. Europe’s balance of payments crisis is not disappearing any time soon.

The latest Euro Area Bank Lending Survey reports that 35 per cent of banks tightened lending conditions to European non-financial corporations. The money supply in the periphery contracted by 4 per cent in the year to November. Spanish industrial production fell by 7 per cent over the same period. The dire economic prospects for the periphery are exacerbated by Germany’s insistence on fiscal austerity.

The ECB’s action has brought a liquidity crisis to an end. But it is unlikely to spur lending in the real economy. Until the economies of Europe’s periphery start to grow, concerns about their solvency will continue.

Edward Chancellor is a member of the asset allocation team at investment manager GMO