Draghi Mulls Negative Campaign as Economy Struggles

Draghi Mulls Negative Campaign as Economy Struggles
Mario Draghi, president of the European Central Bank speaks during a news conference following the ECB rate announcement in Bratislava, Slovakia, on May 2, 2013. Photographer: Martin Divisek/Bloomberg

European Central Bank President Mario Draghi is signalling he may go negative in his campaign to rescue the euro-area economy.

With the ECB cutting its benchmark interest rate to a record low yesterday as the euro-area recession deepens, Draghi said policy makers have an “open mind” on reducing their so-called deposit rate below zero for the first time.

Forcing banks to pay when parking cash at the central bank would be aimed at spurring them into lending rather than saving, yet economists say the step may backfire. That it’s even being considered highlights the weakness of the 17-nation economy and rekindles Draghi’s reputation for unorthodoxy.

“Draghi has shifted the ECB’s stance on the potential floor for interest rates,” said Marchel Alexandrovich, senior European economist at Jefferies International Ltd. in London. “A negative deposit rate is now a more distinct possibility.”

Alert to the potential for fallout, Draghi said that while there may be “unintended consequences” from using the tool, the ECB is “technically ready” and would “address these consequences if we decide to act.”

Bond Reaction

The discussion alone is enough to encourage demand for European bonds by getting “the market fired up on the idea that the ECB is about to take fixed income into a new territory,” said Harvinder Sian, a senior fixed-income strategist at Royal Bank of Scotland Group Plc in London.

Germany’s two-year note yield dropped below zero yesterday, and the rate on 10-year bunds fell to the lowest level since July, when the ECB last cut borrowing costs. The rates on French, Finnish and Belgian 10-year debt slid to all-time lows.

There is reason to sell the euro on such “verbal intervention,” said Scott Thiel, deputy chief investment officer of fixed income at BlackRock Inc. in London. The euro declined yesterday for the first time in five days against the dollar.

The single currency rose 0.3 percent today to $1.3103 after ECB council member Ewald Nowotny said policy makers have no plans at the moment to cut the deposit rate below zero and that market reaction to Draghi’s comments was exaggerated.

While it is “one of many options,” it’s “not an option that is relevant for the near future,” Nowotny said.

Encourage Lending

Paring the deposit rate below the zero would theoretically discourage banks from leaving money with the ECB overnight, potentially prompting them to lend it instead. About 120 billion euros ($157 billion) is currently being deposited with the ECB each day.

The ECB is keen to rally banks, which account for about 80 percent of corporate financing in the euro area, compared with less than 20 percent in the U.S. Lending to households and companies in the region contracted for a 10th month in February, and small- and medium-sized companies, which account for the bulk of employment in Italy and Spain, have been particular victims.

The Federal Reserve and Bank of Japan have avoided negative deposit rates, and Bank of England Deputy Governor Paul Tucker said this week they are “most unlikely” to be deployed in the U.K. Denmark is the only country in Europe to currently have a rate below zero, although Sweden’s Riksbank and the Swiss National Bank have been there in the past.

Potential ‘Complications’

With Italian and Spanish banks leaving just 31 billion euros and 11 billion euros inside national central banks each night, such a shift is unlikely to generate lots more cash for those economies, said Alexandrovich at Jefferies. He said the ECB may instead try to prod banks in Germany and other stronger economies to invest in riskier assets such as Spanish debt.

The potential danger is that a deposit-rate cut may end up hurting banks’ profitability by lowering money-market rates, potentially hampering credit supply to companies and households even further and reducing banks’ incentive to lend to counterparts. ECB officials, including Executive Board member Benoit Coeure, have previously highlighted such issues.

“It raises all sorts of complications and what you get is only modest stimulus,” said Jens Larsen, chief European economist at RBC Capital Markets in London and a former Bank of England official. “I don’t think they’ll do it.”

Reducing Margins

Anatoli Annenkov, an economist at Societe Generale SA in London, said that a move to a negative rate may create an incentive not to lend.

“The big fear is that it might increase the costs for banks, he said. “If margins are reduced, they might be even less willing to lend.”

Annenkov said that Draghi was probably attempting to “show there’s still room in the ECB arsenal” and that it’s more likely to narrow the corridor between the benchmark and deposit rates before considering charging banks for deposits.

The focus on the deposit rate eclipsed the ECB’s decision to cut its benchmark rate by 25 basis points to 0.5 percent. Draghi indicated some policy makers wanted to go even lower.

In a week in which data showed inflation at its weakest since 2010 and unemployment at a record 12.1 percent in the euro area, Draghi also extended the ECB’s policy of lending to banks as much as they want by a year to mid-2014. The bank previously announced six-month extensions. The ECB is talking with European institutions about ways to speed credit to companies using collateralized loans.

Transmission Mechanism

Even with easier monetary policy, the ECB may struggle to gain traction when the transmission of its rates is hampered by Europe’s three-year debt crisis.

While the cut will reduce banks’ refinancing costs by about 2.5 billion euros, especially for those based in the so-called peripheral countries, Holger Schmieding, chief economist of Berenberg Bank, said “the major monetary problem” remains the credit crunch for businesses rather than the level of ECB rates.

Still, Draghi is turning aggressive again having previously lowered interest rates, extended longer-term loans to banks and vowed to do “whatever it takes” to save the euro by buying bonds of stressed sovereigns.

“We believe that the ECB will not ultimately move deposit rates into negative territory, and that Mario Draghi was simply showing a masterly example of verbal intervention -- and with success,” said Elwin de Groot, senior market economist at Rabobank Nederland in Utrecht.

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