The IMF on Tuesday repeated its call for the ECB to reduce policy rates in the eurozone, and Mario Draghi came fairly close to promising action in May at his press conference after the governing council meeting on April 4. But no-one really believes that the expected 0.25 percentage point cut in the main refinancing rate will do very much to solve the eurozone’s most pressing problem, which is the lack of bank lending to small and medium sized enterprises (SMEs) in the troubled economies.
Monetary conditions in the eurozone are fragmented. Bank lending rates are, perversely, much higher in the weakest economies than they are in the core. Unless this is solved, the eurozone economy will remain in trouble.
In order to address this issue, the ECB needs to think in ways which are unconventional, and therefore unpalatable for many of the conservatives on the governing council. However, both Mario Draghi and his colleague Benoît Cœuré have recently hinted that they view measures to eliminate fragmented lending rates as essential to fulfil the mandate of the ECB. This is how they justified the introduction of the Outright Monetary Transactions (OMT) programme, which saved the euro last autumn.
They have also said that the power of the ECB in this area is limited, and have argued repeatedly that effective action will require co-operation from member governments and from the European Investment Bank (EIB). It is therefore probable that discussions are under way between the ECB and member states to decide what can be done. There are two options which could have significant beneficial effects.
The first would be the provision of extra liquidity to the banking sectors in the periphery in a manner which would induce them to increase their lending to the SMEs. The UK did this by introducing the Funding for Lending Scheme last year. This scheme incentivises the banks by offering reduced funding rates for those which increase their lending books the most.
The UK Treasury ultimately accepts the risks of losses on these new loans, not the central bank (*see note at bottom). The problem for the ECB is that there is no single fiscal entity which could compensate the central bank for any losses on such a programme. Mr Draghi has hinted the national central banks could become involved, implying that any losses would fall at the door of the finance ministry of the relevant country, not at the door of the ECB as a whole.
This would allow the eurosystem to introduce Funding for Lending Schemes that could differ from one country to another, thus directly addressing the fragmentation problem. Mr Draghi has suggested that “schemes in other countries” have not been particularly successful, but surely such a scheme would be better than nothing.
A more radical proposal would be somehow to involve the EIB in the provision of additional loans to SMEs in the troubled economies. In fact, this is already under way, since member states agreed in 2012 to increase the capital base of the EIB so that it could increase its loan book in the next three years without losing its triple A status in the bond markets. Annual EIB lending will be around €70bn in 2013, up by €20bn on previous targets.
Furthermore, the EIB already has access to the liquidity operations of the ECB, since it is deemed to be a bank domiciled in Luxembourg and is not treated as an arm of government. Its operations therefore do not add to official government debt, although the contingent capital of the organisation, if it were ever needed to be called, would come from the budgets of the member states. This legal construct means that the ECB can lend to the EIB without breaching the treaty restrictions on direct lending to governments by the central bank.
Why not simply leverage the EIB with money from the ECB, and have the former increase its loan book at preferential rates in the periphery? It could lend, as now, to the banks of the periphery, and require them to pass on low rates to the SMEs in their countries.
There are two problems with this.
First, this might lead to a downgrade in the EIB’s credit ratings, unless it raised even more capital. Neither the EIB board, nor the German government, would accept the risk of a downgrade.
Second, if more capital were to be raised, EU members which are not in the eurozone would need to cough up. The UK actually agreed to accept its share of the increased capital call last year, partly because it can benefit from the EIB’s lending operations. But UK domestic politics would make it hard to accept a further capital call to “bail out” the troubled eurozone economies. Perhaps the EIB could operate a special facility on behalf of eurozone members only, funded or even capitalised by the ECB.
If ways could be found to pursue either of these options, the problems of fragmented monetary policy could be significantly addressed. Mr Draghi has warned that this would involve new thinking by governments, as well as acquiescence by the hawks on the ECB governing council. This is proving difficult, as always, but I nevertheless expect some form of action at the May policy meeting.
*UPDATE – 23d April – Gavyn has written a note in the comments, clarifying that there is no indemnity from HM Treasury to the Bank of England for this scheme, meaning that losses from it will appear on the central bank’s balance sheet. Since HM Treasury is the BoE’s sole shareholder, however, the risks of the programme are still ultimately being borne by the UK exchequer.
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