After months of promises, the ECB announced rate cut as well as their plan to launch stimulus package on October 2014. How these two could end Eurozone troubles?

After months of promises, the European Central Bank at last make its move to halt stagnation and dropping inflation in the Eurozone. Yesterday (4/9), ECB announced rate cut as well as their plan to launch stimulus package on October 2014. How these two could end Eurozone troubles?

Ekonomi

ECB Rate Cut

Starting from September 10, 2014, ECB cut its benchmark rate from 0.15% to 0.05%, borrowing rate from 0.4% to 0.3%, and deposit rate from -0.1% to -0.2%. There are four ways ECB rate cut could help the economy:



1. Encourage spending, discourage saving

If benchmark rate is low, then surely deposit rates will be just as low, diminish the reward attained from saving. As saving products lose their advantages, companies and households may choose to spend their money on consumption or business expansion instead. According to economic rhetoric, rising consumption and business expansion could boost growth and push inflation up.



2. Fine bank deposit in ECB

If banks are saving their money in the central bank, then they won't be able to do their job as financial intermediary properly. The funds they have gathered from people's saving could not be channelled to borrowers, and therefore made it difficult for enterpreneurs to get the much needed financing. But if savings in the central bank will cost them money, instead of giving them easy money, then the banks surely will be hard at work to finance the economy. At least, that's how it should be.

 

3. Encourage banks to borrow from ECB

Low borrowing cost is hoped to encourage banks in the area to borrow more from ECB, and redirect the borrowed funds to the economy.

 

4. Boost growth and recover the job market

It is not an exaggeration to say that job market in the Eurozone is in shambles. The low borrowing cost is hoped to bring about changes by reinvigorate the business sector and open more employment opportunities. If it happens and then overall wages grow, it signals that the economy has started to recover.

The new ECB rate cut might marks the end of conventional monetary approach. A number of other central banks have set zero interest before, most notably the Bank of Japan, but the end result of 0% and 0.05% is not that much different. Therefore, to actually make a difference, the ECB needs another tactic. In this opportunity, it seems that they have chosen ABS buying program.

 

ABS Buying Program

The second surprise on ECB announcement yesterday pertains to the plan to start ABS buying program next month. Asset-backed Securities (ABS) refers to collection of assets backed by loan, lease, etc, similar to Mortgage-based Securities. In the ABS buying program, banks in the Eurozone will be able to sell these securitized asset collection to the ECB.

How it will be done? The New York Times explained it in four steps:

  1. The European Central Bank prints money.
  2. The central bank uses the euros to buy packages of bank loans and other asset-backed securities from banks.
  3. The purchases inject additional funds into the financial system.
  4. The extra money encourages banks to lend, stimulating the economy.

For the time being, ECB has not revealed details on how big the buying will be and other details. Further explanation are to be expected on the next announcement in October 2014.

Theoretically, ABS buying probably could reignite Eurozone economy. But in practice, there are a number of obstacles pertaining to the program itself and various complications in the region. ECB Governor, Mario Draghi,  have repeatedly mentioned the urgency of structural reforms and cohesive cooperation between Eurozone countries. But we could see that governments are apparently still fixated on austerity. So, what will happen if ABS buying fail to deliver? Draghi commentaries opened up the possibility of Quantitative Easing at another time.

 

Third Alternative: QE

ABS buying is an alternative to stimulus, but it is of different nature than Quantitative Easing (QE) that was done by The Fed and BOJ. ECB plan seemd to focus on easing borrowing cost for companies and households, while QE targets broader subject. QE refers to sovereign bonds buying program, which means that the central bank takes over the responsibility of funding the government. QE enable the government to spend more, instead of restraining budget spending in the name of austerity.

Why ECB can't agree on QE and set up ABS buying instead? One of the most critical reason is that the Eurozone economic system is unlike an ordinary country.

Bendera
US The Fed were able to put QE in place because they bought uniformed bonds each month that was standardized by the same rules under US government. On the other hand, the Eurozone is composed of a variety of countries with differing regulations and debt composition. These countries made up the ECB as common monetary authority, but the highest share came from Germany Bundesbank. In other word, if the ECB choose to do the QE, then it might put German in the untenable position of becoming the owner of a significant number of worthless bonds. It is said to be one of the reasons why German oppose talks about QE in the ECB.

Apart from German refusal, QE is still a probable scenario to be taken at later date by the ECB. Bloomberg quoted Joerg Kraemer from Commerzbank AG who said that there is still 60% probability that ECB will buy government bonds, as ECB seemed like it is going to reacts to unsatisfactory economic performance.

Although QE is still a possibility, it is fairly safe to say that the ECB surely will need some time to review how the recent rate cut support their target achievement, as well as how the economy will react to future ABS buying. Meanwhile, there is one thing that has been cleared: loose monetary policy like ECB rate cut, ABS buying, and QE has and will always drown the Euro. Euro dropped more than 1% following ECB announcement, and we could expect the impact to be long-lasting. Beside of the impact of the policies themselves, the ECB also likes weak Euro better than strong Euro, and this indirectly influences investors decisions in dealing with the currency.