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

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.

Importance Of Banks

When the Federal Reserve first started its aggressive QE after the 2008-2009 market crash, the banks in the U.S. did not really cooperate. They were focused on reducing leverage ratios and repairing their balance sheets. Naturally, they hoarded capital, tightened credit standards and gave a cold shoulder to those who needed credit.

But the bond market responded much more enthusiastically, with spreads on corporate bonds and mortgages coming down quickly. Eventually the banks did follow suit, but they were definitely not the spark that was needed to jump-start the U.S. economy. Fortunately for U.S. businesses, only 20 percent of their funding relies on bank lending.

The situation in Europe is reversed—fully 80 percent of business capital comes from bank loans. Regrettably, most European banks are not in great shape at the moment. They never cleaned up their balance sheets by recognizing their losses from the financial crisis in 2008. Most of them are still on the books, hurting their capital ratios and impairing their ability to lend.

Moreover, European banks have large exposure to emerging markets where the percentage of nonperforming loans is rising again. Saddled with old and potential new losses, it’s hard to imagine they will actually use the liquidity provided by the ECB to increase their lending.

Different Mortgage- And Asset-Backed Markets

Another reason to doubt the effectiveness of QE in Europe is the fact that the mortgage market there is far less developed than in the U.S. There are a number of structural and cultural reasons for that. Europeans are much more likely to save most of the money for a home purchase first than to take out a mortgage with a 5 percent down payment.

And even when they purchase a residence with credit, the banks usually hold on to the loans. In the U.S., most mortgages get sold to government-sponsored entities like Fannie Mae and Freddie Mac, which frees up the banks’ balance sheets to extend more credit.

The same is true for other types of consumer loans. American financial institutions quickly securitize and offload them onto the capital markets. In contrast, European lenders tend to accumulate the loans on their books, clogging the channels through which monetary policy is supposed to work.

These impediments to credit-creation in Europe are only made worse by the regulatory fragmentation of financial markets on a national level and by the strong home biases that many investors there hold.

Takeaway

Let me be clear: The ECB’s actions and the currency effect they have generated so far do provide some cover and time for policymakers to figure out a plan that could potentially revive the eurozone’s economy. But they should be viewed as a temporary relief, not a panacea for Europe’s woes.

Without economic reforms, appropriate fiscal policies and further political integration, the quantitative easing is not likely to succeed.

Last year, I wrote how currency hedging makes little sense for the long-term equity investor since it relies on correctly predicting currency trends (Case Against Currency-Hedged ETFs). Here again, ETFs like HEDJ may outperform other unhedged funds for a while, but it’s likely to be a fleeting phenomenon.

Investors should be mindful of this and watch for positive signs beyond the depreciation of the euro along the lines of what I laid out above before jumping into the eurozone with two feet.

At the time this article was written, the author held no positions in the security mentioned. Contact Boris Valentinov at [email protected].