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Great Monetary Polarisation and the euro liability drive

Great Monetary Polarisation and the euro liability drive

Once again, euro becomes world’s favourite borrowing currency 

by David Marsh

Mon 9 Mar 2015

The most notable result of today’s start of quantitative easing by the European Central Bank seems likely to be a weaker euro as one of the most visible – and potentially disruptive – side-effects of the Great Monetary Polarisation. With the timetable for a rise in US interest rates quickening after Friday’s news of a fall in US unemployment to a 5½ year low, the world’s largest monetary blocs are running diametrically opposing interest rate policies.

On worldwide capital markets, as illustrated by a sharp rise in Chinese companies borrowing in euros, the race is on to build up euro liabilities.

A combination of euro weakness, low interest rates and the burgeoning US recovery is propelling the European economy towards faster growth. If this continues, and especially if inflationary pressures start to rise again as the oil price rebounds, calls will rise from Germany and other creditor countries for Mario Draghi, the ECB president, to end the QE stimulus before the planned cut-off of September 2016. Draghi has consistently signalled since August 2014 that a lower euro is a comprehensive part of the ECB’s strategy. So he will be unwilling to signal any let-up in the easing drive unless there is incontrovertible evidence of a move back to the ECB’s reference rate of 2% inflation.

The woes of Greece and other debtor nations will restrain any European euphoria. But the ECB’s accommodative stance and higher interest rates elsewhere are likely to make the euro, once again, the world’s favourite borrowing currency – a repeat of the euro’s initial weakness in the years after it was launched in January 1999. 

Many effects of today’s launch of the ECB’s €60bn a month programme of asset purchases – six years after equivalent action in the US and UK – are likely to be counterproductive. Among the principal beneficiaries of the weaker euro will be German exporters, exacerbating the chronic multi-year problem of excess German current account surpluses that has been both cause and consequence of the European debt crisis.

The constituent central banks of the euro area – each buying bonds primarily from its own country on an own-account basis, reflecting German refusal to shoulder other member states’ risks – will probably end up with unequal shares in the programme. 

The ECB constituents are supposed to be buying government bonds on a GDP-weighted basis. But the Bundesbank may start with a smaller-than-quota role in the purchases, reflecting the reluctance of many holders of German government bonds to sell paper needed for regulatory or prudential purposes, despite historically high bond prices.

The Bundesbank is reluctant to pay over-the-odds to purchase German government bonds, fearful of adding to the trend of negative interest rates across an estimated $3tn of prime-rated bonds worldwide. The Bundesbank does not wish further to stoke up asset price bubbles that many believe are already growing thanks to excessive cheap money policies by international central banks.

Holders of higher-yielding Italian and Spanish bonds, on the other hand, may be less reluctant to sell their stocks to their respective central banks, seizing the opportunity to take profits after sizeable increases in peripheral countries’ bond prices in the last three years. The ECB QE programme will compound a squeeze in supplies to capital markets of top-rated government paper in heavy demand for collateral purposes.

To overcome a growing supply-demand collateral mismatch, the ECB is inaugurating large-scale securities lending by constituent central banks, drawing lessons from US and UK practice six years ago when central bank buying of government bonds led to a sizable drain in collateral availability.

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