A badly timed euro zone tightening: James Saft

January 30, 2013

Jan 30 (Reuters) – A bank-led credit crunch, a newly strong
euro and the shrinking of the European Central Bank’s balance
sheet are tightening conditions in the euro zone at just the
wrong time.

This should heighten pressure on the ECB to cut rates or
take other measures when it meets next week. Just don’t count on
the central bank doing much.

A confluence of forces, some positive, are combining to
effectively tighten financial conditions in the euro zone, even
as the continent struggles with unemployment and recession.

Healthier, more stable banks are repaying longer-term funds
borrowed from the ECB, an encouraging development but one which
has as a side effect higher market interest rates.

At the same time, banks continue to be fearful and stingy
about making loans, both to consumers and businesses.

Finally, and perhaps most damagingly, the euro is
shooting up in value against the currencies of major trading
partners, driven partly by relief that the euro project seems
less fragile and partly by conviction that the ECB will be less
generous than its peers.

The net result is that Europe is suffering from tighter
conditions at just the juncture at which money should become
cheaper.

And yet not one of the 75 economists polled by Reuters
recently expects the ECB to cut rates at its Feb. 7 meeting. If
they don’t we can expect more euro strength and more economic
weakness.

Banks taking part in the ECB’s quarterly lending survey said
they found it easier to raise funds themselves. When it came to
lending the money on, however, they continued to ratchet lending
standards tighter at roughly the same rate as the quarter
before. Credit standards for households tightened at an
increased rate. Demand for loans also fell, a decrease that
probably allowed banks to be more generous than they otherwise
would be. here

Even so, corporate loans outstanding in the euro zone
declined by 52 billion euros in December alone, falling by more
than 9 billion euros just in Italy. In an economy with a less
deep public capital market, and one with a huge host of
loan-dependent small and medium-sized business, this picture of
a lending drought is very negative.

BANKS RECOVERING, ECONOMY NOT SO MUCH

Banks clearly are doing better than they were months ago,
helped immensely by the ECB’s effective backstopping of
sovereign creditors and the euro project as a whole. The problem
is that while banks and countries are finding it easier to
borrow, people and businesses are not so lucky.

The huge rush to repay funds borrowed from the ECB in the
Long-term Refinancing Operation is a case in point. The ECB said
last Friday that 278 banks would repay early a total of 137.2
billion euros of three-year loans they took out in December
2011, funds actually repaid on Wednesday.

That was far more than markets expected, and showed that the
banks were finding their own funding conditions to be more
stable. The repayment, though, is having a paradoxical effect,
being in itself a draining of liquidity from the financial
system.

That could be seen clearly in Euribor bank-to-bank lending
rates, where three-month money inched up to 0.23 percent, a
seemingly minuscule amount but nonetheless more than 20 percent
higher since the first of the year. Not a big move in absolute
terms, but hardly one justified by the economic fundamentals.

The other vexing issue is the strength of the euro, up more
than 2 percent against the dollar year-to-date and more than 12
percent since August. Again, we have the paradox of the explicit
ECB insurance policy: in promoting confidence they produce a
tightening of conditions. Euro zone exporters will be feeling
the pinch, nowhere more than in the less competitive areas like
Portugal and Spain, whose situation begs for a devaluation, not
a revaluation.

Don’t expect the pressure to ease. The Federal Reserve
announced it will continue with its extraordinary policies, the
Bank of Japan has unveiled a new, higher inflation target and
plans for more asset buys, and the Bank of England may well do
more as Britain’s third recession in recent years looms.

If the ECB does react by easing, or for that matter by
talking the euro down, it would be a net positive for global
markets which are already floating on a cloud of optimism and
central bank largess.

That said, nothing the ECB has said, much less their track
record, indicates they are close to cutting rates, no matter the
damage. Rescuing the euro, if that indeed is what they have
done, was painful, divisive and forced the central bank to do
things far out of its comfort zone.

For Europe’s real economy, that means more pain to come.
(At the time of publication James Saft did not own any direct
investments in securities mentioned in this article. He may be
an owner indirectly as an investor in a fund. You can email him
at jamessaft@jamessaft.com and find more columns at blogs.reuters.com/james-saft)

(Editing by James Dalgleish)

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