Paying Banks to Lend: The New ECB Measures and Structural Reforms

Of the six latest measures announced by the European Central Bank (ECB) to boost the economy, the most interesting is the Targeted Long Term Refinancing Operation (TLTRO).

Under this program, banks can borrow money from the central bank at an initial interest rate of 0 percent, but are subject to the condition that the money will be lent to consumers and businesses, not for mortgages or any speculative activity. The banks will get a bonus of 0.4 percent annually on the value of the loan after two years with the bonus applied retroactively. Theoretically, the banks can refinance up to 30 percent of their loan books under the new TLTRO arrangement. This program will run for four years and start in June after implementation rules have been set up by the ECB.

TLTRO is designed to relieve the pressure on bank profits as a result of the new -0.4 percent interest that the banks must pay the ECB on their ECB deposits. Even the refinancing rate of bank borrowing at zero interest rate is not going to help the banks as no bank would like to tap ECB refinancing in normal times. Borrowing from the ECB in normal conditions often signals the weak financial position of the bank.

The attempt by the ECB on TLTRO is the first serious attempt in global monetary history on directional and subsidized lending. Whether it will be effective will be interesting to watch.

The decision to push ahead with TLTRO despite the moral hazard of fund diversions to speculative activities signals the desperate state of the European economy. For 2016, the Eurozone Inflation outlook was revised down to 0.1 percent and growth faced a downward revision from earlier forecast of 1.7 percent. Quantitative Easing (QE) is apparently not working in Europe.

The efficacy of QE is being questioned worldwide. The experience from the US, China, the EU, and Japan all point to its limitations and there is an increasing call for higher fiscal spending to boost the economy in lieu of QE. However, with all major countries having a national debt hovering around 80-100 percent of GDP, many argue that such short to medium term additional fiscal deficits must be combined with long term programs of fiscal consolidation to maintain market confidence. However, it is not easy to define the time span of the short, medium and long term under the current uncertain economic environment. This timing issue severely constrains the extent of fiscal expansion required to bring the economy out of its doldrums. The looming demographic fiscal pressure further adds uncertainty to the use of significant fiscal deficits to bolster the economy.

The uncertainty behind the use of extensive monetary and fiscal stimuli leaves structural reform as the critical element to the stagnation issue that the world faces today. However, the issue behind structural reform is often more societal and political rather than economic. Whether the countries facing structural stagnation will pull out the necessary reforms requires more hard work from politicians rather than economists.