The European Central Bank’s Quantitative Easing: Effects and Impacts

Wei Min

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The European Central Bank’s Quantitative Easing: Effects and Impacts

Wei Min

Wei Min is Senior Research Fellow at the Department for World Economy and Development, China Institute of International Studies.

Since 2008, when the global financial crisis erupted, quantitative easing (QE) monetary policy has been the preferred “remedy” of many countries to cure their woes. The European Union, in the aftermath of the global financial crisis and its debt crisis has finally come to the end of the longest contraction since the founding of the euro and to the EU economy is picking up. However, affected by the geopolitical situation and tumbling oil prices, the EU now faces deflation risks and an economic downturn. Following the lead of the United States, the United Kingdom and Japan, the European Central Bank (ECB) in January 2015 put QE into practice, with a scale of about €1.1 trillion, and bought €60 billion treasury bonds and other bonds every month starting from March 2015. This unconventional monetary policy is unprecedented in Europe, and its effectiveness and consequences deserve close attention.

The background to the ECB’s introduction of QE

QE refers to a policy by the central bank at a time when benchmark interest rates are at or close to zero, central banks cannot stimulate the economy by further lowering the benchmark interest rates and have to turn to massive purchases of mid- and long-term bonds to lower long-term interest rates, so as to stimulate investment and consumption by reducing the financing costsfor businesses and ordinary people, and so revitalize the economy. QE was first implemented in March 2001 by the Bank of Japan. But it is the US Federal Reserve’s three rounds of QE after the financial crisis that caused widespread concern in the international community. The ECB’s QE was enacted six years later than the Fed’s QE.

After the onset of the global financial crisis and the European debt crisis, the European economy plunged into recession. The improvement in 2013 did not give a forceful boost to its economic recovery. And in 2014, the eurozone economy was challenged by increasing uncertainties. The geopolitical situation, plummeting oil prices and the normalization of the Fed’s monetary policy increased external risks. The ECB paid close attention to the risks, and made timely adjustments to its monetary policy in a bid to cope with the situation. In April 2014, ECB President Mario Draghi said in the Netherlands that the eurozone might face three emergencies so that Europe had to make corresponding plans. First, in the case of monetary policy tightening by countries outside the eurozone, resulting in rising bond yields or appreciation of the euro, the ECB would respond by taking conventional monetary policy measures (such as interest rate cuts). Second, in the case of sustained damage to bank credit channels, the ECB would implement targeted QE to provide long-term loans to banks or to purchase asset-backed securities (ABS). And third, in the case of inflation deterioration in the eurozone or when inflation expectations fell, an asset purchase program (i.e. QE) would be adopted in the eurozone.

The subsequent development of the economic situation met these assumptions. The ECB thus took appropriate measures to deal with situation. In June 2014 when the Fed hinted at its QE exit, the ECB cut the main refinancing rate down to an effectively low level, and took forwardlooking guidance measures and adopted deposits in the name of negative interest rates, so as to reinforce the impact of interest rate policy on the yield curve. However, changes in the yield curve failed to play a substantive role in boosting eurozone business and the credit of ordinary people, so the conventional monetary policy adopted by the ECB did not achieve theexpected results. After that, the ECB decided to start targeted long-term refinancing operations (TLTRO). Loans were issued to the real economy as a prerequisite and cheap long-term financing was provided to banks, in order to push credit supply and credit interest rates back to normal levels. In September 2014, the ECB announced that it would purchase asset-backed bonds and guaranteed bonds, but these efforts have had little effect because of bank “sparing credits” and limited assets. Finally, the short-term price decline and deterioration of inflation expectations prompted the ECB’s formal introduction of QE. Starting from the third quarter of 2011, the inflation rate in the eurozone continuously worsened, falling from 3 percent at the end of 2011 down to less than 1 percent in early 2014. In the second half of 2014, inflation deteriorated further in the eurozone, with falling oil prices exacerbating the deflationary pressures. As a result, the inflation rate in the eurozone fell to -0.2 percent in December 2014 exceeding the negative inflation rate of -0.1 percent in October 2009. In January 2015, the European continent was shadowed by deflation, and the consumer price index in the eurozone fell by 0.6 percent and 0.5 percent in other EU countries, reaching the lowest points in history.

The efforts made by the ECB were aimed at targeting the impact of short-term falling prices in the eurozone, and more the continued mid-term deflationary pressures faced by Europe.

The ECB was worried that deflation in the eurozone might dampen the prospects of an economic recovery. Meeting minutes of the ECB Governing Council show it was generally agreed that two QEs in June and September 2014 were not sufficient enough to stabilize prices, and efforts were required to prevent downward inflation which might lead to deflation in which real interest rates rose. In this context, the ECB announced in January 2015 the launch of QE to expand the scope of asset purchases to public sector bonds. From March 2015 to September 2016, the ECB is to buy €60 billion per month of member states treasuries and agency bonds; by adding the purchase of sovereign bonds to its existing private sector asset purchase programs theECB aimed to address the risks of prolonged low inflation.

European Central Bank President Mario Draghi (R) attends a news conference in Frankfurt, January 22, 2015, announcing the launch of a government bond-buying program which will pump hundreds of billions of new money into a sagging euro zone economy.

The Governing Council decided that purchases of securities of European institutions (constituting 12 percent of the additional asset purchases and to be purchased by National Central Banks) would be subject to loss sharing. The rest of the National Central Banks’ additional asset purchases would not be subject to loss sharing. The ECB would hold 8 percent of the additional asset purchases. Thus 20 percent of the additional asset purchases would be subject to a regime of risk sharing.

Two points were specified in this round of QE: bond purchases would be stopped when eurozone inflation approached 2 percent; and if inflation failed to improve as expected, the bond purchase period would be extended. Thus it can be seen that the ECB’s QE is clearly intended to deal with deflation.The efforts made by the ECB were aimed at targeting the impact of short-term falling prices in the eurozone, and more the continued mid-term deflationary pressures faced by Europe. Neither the International Monetary Fund (IMF) nor the ECB were optimistic about the mid-term price level in the eurozone. The ECB lowered its inflation forecast for 2015 in the eurozone from 0.3 percent to 0.1 percent, and reduced its 2016 and 2017 inflation forecasts from 1.5 percent and 1.8 percent down to 1.1 percent and 1.7 percent respectively. The primary objective of the ECB is to maintain price stability and achieve a mid-term inflation rate of no higher than, but close to, 2 percent.

Effectiveness of the QE implementation

Large scale QE measures by the ECB have stimulated the EU economy. Boosted by falling global oil prices and devalued euro, the EU economy has begun to see improvement. The EU economy is expecting a relatively low growth rate as the manufacturing index rises, the stock market rallies, some capital flows back to Europe and export activities expand. In December 2015, the ECB predicted that the eurozone economy would grow by 1.5 percent in 2015 and 1.7 percent by 2016.

QE has stimulated the financial markets.

(1) Bond yields declined sharply and financing costs fell. A direct consequence of the QE was a distinct drop in bond yields. The sovereign bond yields of all eurozone countries, except Greece, have fallen to a record low. AAA grade sovereign bond yields declined sharply. In April 2015, German 10-year bond yields fell to the lowest level of 0.16 percent. Ireland had to accept the “troika” bailout, its three-year bond yields fell to a negative value, and its 10-year benchmark bond yield was only 0.81 percent, significantly lower than the United Kingdom’s 1.57 percent and the United States’ 1.95 percent.

By the end of October 2015, the ECB signaled continued QE whichexacerbated the shortage of positive yield assets. The negative yield bonds in the eurozone jumped from €2 trillion to €2.6 trillion in a week. Of $6.3 trillion European sovereign debts, 30 percent of the bonds were negative yields. For the first time, five-year sovereign bonds turned negative with an average yield of -0.025 percent, a record low. Investors have a high demand for safe assets. Very low yields help reduce financing costs and expand credit.

(2) Inflation rebounded. QE can help increase inflation through the release of liquidity, pushing up asset prices and currency depreciation, and uplifting imported commodity prices. After the announcement of QE in the first quarter of 2015, the eurozone inflation index rebounded and remained stable. However, as oil prices fell further, and the Fed failed to raise interest rates in September 2015, the euro once again appreciated, causing the risk of downward inflation. The ECB decided to extend the duration of its QE and enlarge the scope and scale of asset purchases.

Large scale QE measures by the ECB have stimulated the EU economy. Boosted by falling global oil prices and devalued euro, the EU economy has begun to see improvement.

In September 2015, ECB President Mario Draghi announced that the bank might intensify its QE efforts. He acknowledged that the economic downturn in emerging markets had led to the reemergence of the risk of an economic downturn, and that falling oil prices and the slowdown in global trade had made it difficult for the ECB to realize its inflation target. He said that the ECB was determined and had the ability to resort to all policy tools within its portfolio, in particular the asset purchase program, and the ECB could show flexibility by making adjustments to the QE in its scale, composition and duration. Draghi also announced that the ECB would raise the limit for single country bond purchases from 25 percent to 33 percent. He stressed in October 2015 that in December the ECB would reexamine its QE. Discussions were held concerning the possible consequences of lower deposit rates. In December 2015, the ECB announced deposit rates would be cut by 10 basis points to 0.3 percent, and QE would extended until March2017, with an enlarged debt purchase and unchanged bond purchase size.

(3) Further depreciation of the euro is possible. The QE injected a lot of liquidity into the euro market and lowered the euro’s exchange rate. After the implementation of QE in the latter half of 2014, the euro’s exchange rate against the dollar fell from €1.4 to the recent €1.05, a decrease of 27 percent. Since the ECB’s announcement of QE, the euro’s exchange rate against the dollar has been at a record low over past 11 years. Because expectations the Fed would increase interest rate were dampened in September and December of 2015, the EU’s second QE was smaller than expected, resulting in a small bump to the euro. Accordingly, to achieve devaluation of the euro, the ECB has cut the overnight deposit rate, extended the QE term and enlarged the scope of debt purchase. It is expected that the euro will further devalue against the dollar by reaching parity or even fall below the dollar. Being a firm shortseller of the euro, Goldman Sachs predicted that the euro could fall to € 0.95 against the dollar. Goldman Sachs, after the ECB meeting in December 2015, postponed this forecast predicting six months of euro-dollar parity.

Impact of QE on the real economy

With continued QE, the highlights in the real economy in the eurozone are as follows:

(1) Manufacturing index rebounds. PMI data shows the eurozone economy has improved with steady speed. In December 2015, the manufacturing PMI initial value was 53.1, the highest level for 20 months. The eurozone PMI has kept growing for 30 consecutive months, and has remained above the threshold of 50 that separates expansion from contraction since July 2013. The eurozone economy, in the fourth quarter of 2015, is likely to record its most significant growth for four and a half years.

(2) The trade surplus has expanded significantly. The expanded trade surplus also shows that the eurozone economy is continuing to recover. The lower exchange rate of the euro has been conducive to enhancing the competitiveness of eurozone products outside the region, especially those EU member states such as Ireland, Luxembourg and others which dependstrongly on markets outside the eurozone. In 2015, the euro depreciated 10 percent against the US dollar. According to the IMF, the eurozone current account surplus in 2015 expanded by 3.2 percent, that is 2.0 percent higher than the previous year; and the eurozone economy grew by 1.5 percent, that is 0.9 percent higher than that in 2014.

(3) Private consumption has risen. With the support of the large-scale QE, household credit has rebounded significantly in the eurozone, private consumption has grown steadily, and the labor market has improved. In September 2015, sales of private cars rose by 0.6 percent over the second quarter, and the unemployment rate fell to 10.8 percent, the lowest level since early 2012. In November, consumer confidence levels continued to rise, and private consumption increased steadily.

But although the eurozone economy has witnessed some improvements as the result of the implementation of QE, its GDP after deducting price factors has seen almost no growth since the global financial crisis. In some countries, real living standards are in decline. Structural unemployment and the decline in business investment in the region are proving hard to change. The ECB, while continuing to perform QE, should make efforts to carry out vigorous structural economic reforms.

Structural economic reforms should be carried out alongside QE.

The root cause of the weak eurozone economy lies in the structural economic problems of member states, rather than just a lack of liquidity. Therefore, QE is unlikely to solve the problems in the region. Furthermore, the ECB must stick to its portfolio, instead of forcing governments of member states to reform. Draught pointed out that the ECB could not be expected to work out objectives that should be made by other policymakers. He said that the ECB would carry out the task of stabilizing prices, but any improvement of the economy depends on each independent state in the eurozone, and the strengthening of the EU institutional structure depends on the eurozone as a whole.

(1) Structural reform and fiscal consolidation are a slow process. To solve the structural problems in the eurozone economy, efforts are needed to address uneven development between core countries and peripheral countries in the region, and imbalances between low output and high welfare. Greater endeavors are also needed in the adjustment of the industrial structure, reductions in social welfare spending and fiscal austerity. This depends on continued improvement in the labor market, pension market and business environment. In fiscal consolidation, priority should be given to investment and growth friendly expenditure, in order to improve the effectiveness of the tax system and to rein in unbridled welfare spending and the public deficits. QE has positive impacts. It can alleviate economic difficulties in EU countries so as to win more time for their structural reforms. However, QE also has a negative impact as it dampens enthusiasm for reform in these countries. For countries in the eurozone, and the EU economy as a whole, the most important task at present and in the future is to ensure sustained economic growth through reforms.

(2) The debt problems in the eurozone have worsened because of QE. Some countries have taken advantage of low interest rates to increase lending while others have reduced their fiscal austerity, resulting in debt stock expansion. Data from the Statistical Office of the European Union show that, in the first quarter of 2015, the average debt level in the eurozone countries had reached 92.9 percent of the average GDP (compared to 91.9 percent in 2014). Greece, the country heaviest in debt, has a debt rate of 169 percent its GDP. The government debts of Italy, Belgium, Cyprus and Portugal exceeded 100 percent of their respective GDPs. Yet prior to the global financial crisis, the eurozone’s debt accounted for only 60 percent of its total GDP.

(3) The banking system in the region remains fragile. The fragile banking system has been an obstacle restricting regional economic development. And the problem has become more prominent with the implementation of QE. Since the second half of 2012, the ECB has pushed forward a series of measures to reshape confidence in the banking system in the region. In April 2014, the European Parliament adopted an institutional framework for a bankingunion which helped the banking sector weather the crisis. In October, stress tests for the banking system were completed in the region, the banks’ balance sheets were improved, and the market’s confidence in the European banking system was restored. In November, a supervisory mechanism for the eurozone banking system was officially put into operation; and in January 2015, a regional single clearing mechanism was put in place. These measures removed fragmented supervision and regulating of the financial system, so that the ECB, in its QE implementation, could convert the QE policy to easy credit conditions, and give strong support to expand the investment of the private sector. However, the European banking sector is still faced with inadequate profitability, a serious capital gap and rising non-performing loans (NPL). The Financial Stability Assessment report published by the ECB in May 2014 shows that, in the second half of 2013, more than 50 percent of large banking groups in the region suffered losses, and the European banking sector in general has a low-earnings ratio and even losses; the NPL rate reached as high as 5.6 percent, 3.4 times higher than before the financial crisis, and the rate was double the average level in the United States. Plagued by bad loans, it is almost impossible for the European banking sector to increase credit.

Negative effects of QE

QE obviously stimulates financial markets, yet there remain certain drawbacks. Some ECB Governing Council members hold different views on the timing and tools for QE. In particular, with the implementation of QE, negative effects emerged, such as asset shortages, less enthusiasm for structural reform by member state, degenerated professional ethics and risks of financial bubbles.

The “depletion” of quantity

As more and more asset yields turned negative, people began to be concerned about the negative effects of the ECB’s bond-buying program. Citigroup data show that of bonds over one year issued by the Germangovernment, the return was less than zero on 57 percent of them and on nearly one-third the return was -0.2 percent. The ECB said that excessive low yield will hinder its asset purchase activities.

Investors have been forced to turn to the corporate bond market since treasury yields have fallen to such unprecedented low levels. With the impacts of QE, corporate bond yields have generally declined in Europe. According to the Financial Times, two-thirds of the euro-denominated corporate bond yields have fallen to 1 percent or less. Declining corporate bond yields stimulated to a great degree the issuance of corporate bonds. According to UBS data, the investment bond issuance in the first quarter of 2015 rose by 41 percent year-on-year, reaching €97 billion. Many enterprises are in favor of issuing longer-term bonds. With sovereign debt yields falling to zero, and corporate bond premiums being further cut, the result is “dry-out” and “depletion” problems for euro assets.

The ECB may follow the steps of the Japanese Central Bank.

The bond market in the eurozone is not very developed and there are a limited number of high-quality government bonds. Therefore bonds are in short supply. Given the asset scarcity in the eurozone and limited options for the ECB, not only non-financial corporate bonds have been enlisted, but also wholesale lending and sub-grade sovereign debt have been enlisted as well, shares can be even purchased directly. Some public opinions hold that the ECB is likely to adopt the stimulus formula taken by the Central Bank of Japan, that is, all assets can be purchased in order to support the stock market and government-bond market. It is estimated that the asset size is about €19 trillion after purchase expansion by the ECB.

Pressures on non-eurozone currencies

To protect the Swiss franc from excessive setbacks, the Swiss National Bank (SNB) took steps to lower the Swiss franc’s interest rate to a record low before the ECB started the QE. In January 2015, the SNB announced it would discontinue the minimum limit for the exchange rate between theeuro and the Swiss franc, and the euro devalued against the Swish Franc about 15 percent within two weeks. A month before and after the introduction of QE, Denmark had four consecutive rate cuts, and was directly involved in the foreign exchange market to maintain a stable exchange rate between the Danish krone and the euro. When the ECB expressed its desire to reevaluate its monetary policy in December 2015, the Swedish krona again faced appreciation pressures, and policymakers in the Swedish Riksbank were depicted as standing by the Baltic Sea and holding just a hose as the weapon to deal with the striking wave of capital from the eurozone.

New financial risks have been created because of the deviation between European and US monetary policies.

In October 2014, the Fed concluded its final asset purchase transaction in QE3, making the start of its formal exit from its QE policy. And in December 2015, it began raising interest rates. At the same time, the Bank of Japan stepped up its quantitative and qualitative monetary easing (QQE) efforts. The ECB’s QE implementation coincided with the Fed’s exit from its QE3. Thus the unsynchronized monetary policies of Europe and the United States intensified.

The deviation between the monetary policy of the United States and European Union increased not only the scale and frequency of speculative capital flows in the world, but also exacerbated uncoordinated monetary policies, which could result in new financial risks. The increments in currencies brought by the QE did not enter the real economy, instead they were chasing profits in the financial system. Such a situation contributed to internal market bubbles as a result of QE, and intensified the turmoil in the world financial markets. The QE implementation brought about much cheap capital, yet the exit of the Fed from its QE, as well as the follow-up rate hikes, has also created severe capital outflows and financial turmoil in emerging markets. Preventing systematic financial risks as the result of the differing US and European monetary policies has become a major concern today.

A comparison of the differences between the US and EU QE policies

The United States began its QE after the global financial crisis. The Fed has implemented three rounds of large-scale QE measures, resulting in the US balance sheet increasing from about $900 billion in August 2008 to $4.5 trillion by the end of October 2014. With the US dollar being the dominant currency in world trade, the United States has implemented QE policy willfully in disregard of other countries, and its QE has had global impacts. It can be said that that if the United States exercises QE, the whole world pays for it. However, the euro does not enjoy a leading position and so the EU’s QE has not had the same global impacts. The monetary union in the eurozone restrains the role QE is supposed to play. The United States and Europe have implemented quite different QE. To be more specific, the differences are as follows:

Distinct difficulties

When the Fed implemented its QE, the problem it confronted was a shortage of liquidity caused by the insufficient confidence of investors. By showing the market its determination to combat the crisis and by injecting sufficient liquidity through large-scale asset acquisition, the Fed helped the US economy recover. However, in the eurozone, the problems are structural, such as the inflexible labor market, high welfare system and other issues, all which have to be addressed. Therefore, QE alone is not enough to achieve sustainability in economic development.

Different QE scales

The monthly bond purchases of €60 billion in the eurozone are higher than market expectations, yet still less than Fed’s $85 billion in its third-round of QE. In comparison with the total value of the eurozone economy, the purchase scale was inadequate. At present, the eurozone unemployment rateremains high and economic growth is still hovering at a low level. Standard & Poor, the international rating agency, warned that the eurozone recovery needs at least three years of QE and a stimulation of over €2.4 trillion.

Different financing structures

Unlike the US financial market which relies on direct financing, the eurozone financial market mainly focuses on bank loans. Bank credit in the eurozone accounted for up to 70 percent of the total social financing, while securities accounted for less than 20 percent in 2014. That means that the main field where the QE should play its role is not in capital market, but rather in the credit market where uncertainties prevail. Therefore, the European Union is confronted with more challenges than the United States. Relevant research shows that QE cannot effectively increase bank lending, nor increase imports in the region. Lending reluctance in the eurozone is more serious than in the United States so that European SMEs, which rely mainly on bank financing, have more difficulties in financing.

Dissimilar bond purchases

The United States is a sovereign state, its QE purchases are national government bonds or agency bonds. The eurozone is a monetary union composed of 19 sovereign states, and European QE purchases involve both the ECB and the NCBs of member States. The purchased bonds are issued not only by European institutions, but also by member-state governments and agencies; part of the purchase risks are undertaken collectively in the eurozone, the rest are shouldered by member states. It is more complicated for QE to be carried out in Europe, and greater policy coordination is required. In addition, the purchase of national bonds is allocated according to the investment proportions of the national central banks in the ECB. Germany and France contributed a larger share but gained very low bond yields, while Greece and Portugal and other southern European countries invested less but gained high bond yields. As a result, QE couldn’t effectively allocate the funds to high-risk nations, and its role in lowering bond yields has been weakened.

Different impacts

The special economic features in the eurozone have led to more difficulties in the implementation of QE, and QE’s effectiveness has been greatly compromised. First, monetary policy and fiscal policy should complement each other to achieve the best macroeconomic regulation effects. However, with a unified monetary policy plus independent fiscal policies in the region, and with their strict fiscal consolidation and deficit constraints, the member states find it hard to take advantage of record-low sovereign bond yields to increase their leverage and expenditure. Lack of coordination in monetary and fiscal policies resulted in ineffectiveness of the QE. Second, US and European consumers have different asset structures, and this has led to different effects when the United States have push forward their respective QE efforts. In the eurozone, personal financial assets account for only 49 percent of household wealth, 82 percent less than that in the United States. Therefore, the QE enacted by the United States brought about more wealth effects in lifting asset prices than in Europe. Moreover, household wealth in Europe, to a large extent, is bank deposits, and the falling interest rates due to QE hurt European household incomes and consumption. Third, some European countries are skeptical of QE, which undoubtedly affected the effectiveness of the policy. German Finance Minister Wolfgang Schaeuble said that excessive credit, instead of solving structural problems, will lead to financial and debt crisis. He warned policymakers not to fall into a trap of low interest rates to stimulate the economy, otherwise it would be tantamount to a “drug addiction.”

Unsynchronized QE cycles

While QE was being implemented in Europe, the United States exited from the QE and started raise interest rates. This has undoubtedly led to more capital outflows to the United States and had a negative impact on Europe and newly emerging markets. Certainly, the QE effectiveness in Europe will be offset by capital outflows, thus posing new challenges to the ECB’s follow-up monetary policy.

Conclusion

The ECB, by implementing QE, intends to achieve price stability. However, more time is needed to evaluate the effectiveness of QE and its impacts. QE has had clear-cut effects on stimulating financial markets. Yet, owing to the smaller eurozone bond market and the banking system’s poor recovery, there remain many uncertainties about the effectiveness of the European QE. A truly sustainable recovery is yet to be seen in the real economy, and structural problems such as heavy debts, insufficient long-term investment, and labor market inflexibility remain to be solved. The member-state governments should engage in further practical reforms. However, the QE by the ECB reduced the urgency for reforms in some countries, gave birth to the risk of a financial asset price bubble, affected the euro’s international status, and did not help boost the long-term competitiveness of the European economy.

China and the European Union are important economic partners. The ECB’s monetary policy may have an impact on China via exchange rates and capital channels. Depreciation of the euro will exert pressure on Chinese exports to the eurozone, yet it will be conducive to China’s further expansion of overseas investment. European QE will neutralize to a certain degree the reduced liquidity caused by the United States exit from its QE. The divergence in monetary policies between the United States and the European Union and the tumbling oil prices have made the international financial market more turbulent. While China is confronted with turning points in its international balance of payments, foreign exchange reserves and the renminbi’s exchange rate, the double surplus pattern of international payments has basically ended, long-term foreign reserves growth has been reversed, and the market-oriented reform process of the renminbi’s exchange rate has been accelerated. How to seek advantages and avoid disadvantages in the evolving global financial landscape will test the Chinese leadership’s resilience and wisdom.