July 22, 2014

Kenneth Orchard T. Rowe Price's portfolio manager of European Fixed Income.

The European Central Bank's (ECB) latest easing measures are bold, but are they enough to alleviate tight financial conditions and achieve the desired level of inflation in the eurozone? Below, Ken Orchard, T. Rowe Price's portfolio manager of European Fixed Income, discusses the new funding facility, targeted longer-term refinancing operations (TLTRO). He believes its effect will be limited, and the ECB will have to consider further measures in 2015, including significant quantitative easing.

The ECB's easing package, which was announced in June, has more than met the market's expectations. While the rate cuts were expected, it is the announcement on TLTROs that is most significant.

The success of the TLTRO program, which allows banks to borrow funds up to four years at 0.25%, will be measured on whether it stimulates bank lending to the nonfinancial private sector. Specifically, the ECB wants to encourage more lending to corporates, especially in the periphery.

TLTRO is structured to give banks a large incentive to participate. Four-year funding at a fixed rate of 0.25% is well below where even the strongest banks can obtain funding in the market. The hope is that they will use the new, cheaper funding to increase lending to small and medium-sized enterprises (SMEs). However, there is nothing explicit in the conditions that will prevent banks from using the funds to buy sovereign bonds. Banks are not eager to expand lending in the current macroeconomic environment. Demand for loans also remains weak.

The TLTRO Framework

  • A four-year funding facility launched in two installments: September 2014 and December 2014. The maturity date for both installments is set at September 2018.
  • The interest rate will be fixed based on the main refinancing rate at the time of borrowing (currently 15 basis points) plus a 10-basis-point spread. As of today, the interest rate on the TLTRO will be 25 basis points.
  • Banks are allowed to borrow no more than 7% of their loan book (excluding public sector and mortgage loans) as of April 2014. That totals around €400 billion.
  • If the banks' net lending falls below a certain benchmark (likely to be the change in net lending in the 12 months from April 2014), they will be required to repay borrowings in September 2016.
  • In addition, the ECB will hold quarterly LTRO operations between March 2015 and June 2016. Banks will be allowed to borrow three times the amount of their net new lending (excluding mortgages) versus a certain benchmark (likely to be the change in loans between the LTRO date and April 2014).

Financial conditions to remain tight in the periphery

We expect TLTRO's effect on the real economy to be limited and the ECB to take additional measures at a later stage. One problem is that TLTRO will not completely offset the decline in liquidity resulting from the maturation of the old LTRO. European banks, mostly Italian and Spanish, need to repay around €500bn of the old LTRO borrowings by February 2015. The new TLTRO will replace up to 80% of that money, based on the requirement that banks can borrow no more than 7% of their loan book (excluding public sector and mortgage loans) as of April 2014. Other types of ECB liquidity (for example, seven-day and three-month borrowing instruments) may cover some of the shortfall, but the ECB's balance sheet is not expected to expand and should remain at a stable level.

ECB to stay on hold this year

The Governing Council is unlikely to consider any new policy measures until after the TLTRO is complete in December and the ABS purchase program is operationalized. President Draghi has stated that additional rate cuts are unlikely. Significant quantitative easing (QE)— buying government bonds—will probably be implemented at some point, although it is unlikely to be this year. Some ECB members still have ideological objections to buying government bonds, so QE is not a fait accompli. Nonetheless, this latest easing package allows the more dovish ECB members to show the hawks that they have tried everything else so that they can start to contemplate QE.

The latest ECB announcement is not a panacea. Rate cuts should help to anchor euro rates at a low level as the Federal Reserve and the Bank of England move closer to implementing interest rate rises. But the healing of the eurozone economy will take time and it remains in a vulnerable state. Japan has shown how difficult it can be to escape the vicious cycle of low growth, low inflation, and high debt.


This material is provided for informational purposes only and is not intended to be investment advice or a recommendation to take any particular investment action. Past performance is not indicative of future results. The views contained herein are as of June 2014 and may have changed since that time.