What the ECB Actually Meant to Say on Thursday

(Bloomberg Opinion) -- The European Central Bank’s response to the coronavirus outbreak will be remembered for a terrible communications blunder. But if you look beyond President Christine Lagarde’s infamous seven words (“we are not here to close spreads”), the ECB package should provide meaningful relief to banks, companies and even governments, as they suffer a sharp and painful economic contraction.

The ECB measures will only work, however, if the economic shock from Covid-19 is indeed temporary, as the central bank assumes. At the moment, scientists offer no certainties that this will be the case. The ECB will have to remain extremely flexible to deal with more sustained damage — and to persuade the financial markets of its continuous support.

The central bank announced three sets of actions to deal with the current shock. These include: New and generous rounds of cheap loans to the banks, so that they can extend credit to small- and medium-sized enterprises; a relaxation of the prudential rules for the banking system, aimed at spurring more lending; and an increase in the ECB’s asset-purchase program of up to 120 billion euros ($133 billion). The ECB didn’t lower its deposit rate, although it did say further cuts were possible.

The provision of very cheap liquidity is the most impressive part of the plan. The ECB will launch new lines of funding for the banks, at a rate that becomes ever more generous if the lender keeps pumping money into the economy. An important innovation is that the borrowing rate can even fall below the ECB’s deposit rate, which currently stands at -0.5%. 

The decision to lower the prudential requirements for banks — allowing them to make full use of their capital and liquidity buffers —  is probably necessary but more dangerous. The hope is that this large release of regulatory capital will again support lending and help prevent a credit crunch. The ECB will also be more flexible in its supervisory actions, which should make banks less worried about keeping credit flowing.

These steps will make banks more vulnerable to the accumulation of more bad loans. However, during such a sudden crisis, the alternative might have been worse. The ECB was right to adopt these relief measures without relaxing its overall rules on non-performing loans.

Finally, the central bank announced that extra 120 billion euros of asset purchases, for corporate bonds in particular. The ECB also explained that it will use as much flexibility as possible in allocating these purchases. if needed, it will deviate temporarily from the so-called “capital key,” which limits how many bonds it can buy from each euro member state. So it can load up on more Italian and Spanish debt, if needed.

The communication of this crucial part of the package was especially poor on Thursday. Euro zone governments are expected to unveil big fiscal packages to help their health care sectors, and to support companies and workers. Some countries, such as Italy, will depend on robust bond purchases from the ECB if they’re to keep borrowing at reasonable rates. In her press conference, Lagarde put great emphasis on the need for fiscal stimulus, but forgot that the ECB has a crucial role in ensuring it can be delivered.

The asset purchases may be more supportive than they first seemed. For all the emphasis on corporate bonds, it’s likely that a large part of the purchases will still be directed at government debt. The ECB should have lifted its self-imposed limits on buying bonds from individual countries. However, so long as all euro zone governments engage in substantive fiscal boosts, especially Germany, these constraints will become less relevant.

The important question is whether the crisis will last longer than the ECB assumes. That’s where the central bank’s messaging should have been much better. In particular, the ECB must be ready to take more action, including a large expansion in its quantitative easing program to support government spending, if that’s needed. Countries should feel they have the ECB’s backing at an incredibly difficult time.

As the central bank runs to correct Lagarde’s communication error, many investors will appreciate that the ECB package was more substantive than they had originally assumed. As the euro zone stumbles further into the unknown on the coronavirus, such mistakes have to be avoided.

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

Ferdinando Giugliano writes columns on European economics for Bloomberg Opinion. He is also an economics columnist for La Repubblica and was a member of the editorial board of the Financial Times.

©2020 Bloomberg L.P.

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