ECB’s QE Helps, But It’s Not A Panacea

February 04, 2015

The European Central Bank is finally following in the Federal Reserve’s steps and unleashing a flood of euros into the eurozone economy. This long-overdue quantitative easing is meant to unfreeze Europe’s credit markets and spur growth and investment in the region. As a welcome side effect, it has also pushed down the euro, helping make businesses more competitive.

 

As a result, investors have become quite optimistic on Europe, with big money flowing into most eurozone ETFs and especially into funds that hedge currency exposure. ETFs like the WisdomTree Europe Hedged Equity Fund (HEDJ | B-49)—which, in addition to the currency hedge, also select exporting companies that benefit directly from the euro’s depreciation—have really taken off.

 

Just last week, HEDJ saw inflows of almost $2 billion. Investors are chasing HEDJ’s recent performance and seem to be betting on the euro’s further decline and its positive effect on European stocks.

 

But it may be too early to pop the champagne cork on Europe. While a weaker currency is very helpful initially, it’s only a temporary tonic. The critical element in getting Europe growing again is to get credit flowing again.

 

That part is very problematic, however. Let me explain.

 

Obstacles To Recovery

A depreciating currency can only take Europe so far on the road to recovery.

 

In an open and connected global economy, currencies adjust with the flow of trade. Countries with a current account surplus—i.e., those that are able to export more than they import—see their currencies rise, and eventually the stimulative effect is erased. For the ECB’s actions to have lasting benefits, the financial system has to be able to translate them into increased money supply and lower rates for businesses and consumers.

 

Traditionally, central banks have relied on lowering the rates on risk-free assets like government bonds to stimulate the economy during a crisis. But when the rates on those assets are reaching a zero boundary (German 10-year bunds are yielding 30 basis points), the only way to ease monetary policy further is through lowering the credit spread/risk premium over the risk-free rate embedded in various financial assets.

 

That’s exactly what quantitative easing in the U.S. managed to accomplish. By making returns on risk-free investments painfully low, it pushed investors out on the risk spectrum, and with that, credit and low interest rates spread throughout the economy.

 

Unfortunately, this monetary transmission mechanism in Europe is weak and inefficient at best. That’s because credit creation there relies heavily on the banking system instead of the capital markets.

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