Whereas some members of the governing council of the European Central Bank were hinting the monetary policy would return back to ‘normal’ sooner rather than later, Mario Draghi, the president of the ECB, had a completely different opinion when he testified at the European Parliament.
According to Draghi, all stimulus measures need to remain in place until the Eurozone returns to a normalized inflation rate, and reducing the efforts of the ECB aren’t even being discussed.
Draghi did confirm the economy of the Eurozone is getting stronger thanks to domestic consumption and investment (rather than seeing a boost caused by external investment and export increases), but it’s still too soon to reduce the asset purchase program which will now very likely be extended.
The ECB has also published its ‘Financial Stability Review’, which assesses the risks and vulnerabilities of the financial system as we know it. According to the ECB, the measures of the systemic stress levels in the Eurozone remained very low thanks to a slight increase of the interest rates which increased the confidence the European financial sector will be able to benefit from a larger interest rate spread to strengthen their performances and balance sheets.
This doesn’t mean the financial sector is out of the woods yet, as the ECB is explicitly warning for specific countries where the Non-Performing Loans are ‘eating away’ the profit generated by the interest spread. There’s pretty much zero doubt the ECB is referring to Italy here, and we discussed the country’s situation last week in this article. As you might remember, two Italian banks which were previously rescued by the tax-payer through a government fund once again need an urgent cash infusion to prevent a collapse.
And whilst higher interest rates on the financial markets are excellent news for the financial sector, the ECB also acknowledges these higher interest rates might actually suffocate both the private and public debt issuers. Not only will the governments have to cough up more cash to fund the interest payments on their government debt, the private sector has greatly benefited from the low interest rates. Just like in the USA, companies issued much more debt than they needed, only to spend it on non-accretive things such as share buybacks and special dividends. One good example here might for instance be Bayer’s attempt to acquire Monsanto in a $66B deal. Bayer was (and still is) planning to fund the entire acquisition with debt. A 1.5% increase in the cost of debt will result in Bayer paying $1B per year more in interest expenses. So it shouldn’t be a surprise the ECB is now also calling higher interest rates one of the main potential systemic risks.
And that’s a little bit a contradictio in terminis. The ECB wants the inflation to increase which would allow it to normalize the benchmark interest levels, but if the interest rates increase without seeing a corresponding increase in the inflation rate (the natural effect of companies passing the higher price levels on to their consumers is a very unhealthy situation.
The higher interest rates for private companies are one part of the equation, perhaps an even more important part is the total debt level. And this is where the ECB is sounding the alarm bell as well. According to data provided by the OECD, the private debt in the Eurozone is higher than the historic average, ànd is higher than for instance Japan, the USA and emerging market countries.
This data confirms the ECB would be nuts to stop its ZIRP and to reduce the asset purchase programme. The interest rates would increase too fast, and possibly push the Eurozone over the cliff again. We told you this before and will do so again; once you’re addicted to cheap debt, it’s really difficult to detox.
The end result? Tens of billions of freshly-printed euro’s will continue to be injected in the system. And it’s not a question of ‘if’ it will go wrong, but a question of when it will go wrong.