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ECB’s ‘whatever it takes’ strategy is still work in progress written by Ira Dugal, published in Mint. July 7, 2014

The global marketplace was a volatile arena in the summer of 2012—very different from the complacent calm we see around us today. Even before the memories of the global financial crisis had started to fade, investors were hit by a full-blown crisis emerging out of Europe. Trouble in Greece had been brewing for a while but it was slowly becoming clear that Greece was the tip of a much wider sovereign debt problem in Europe.


By July that year, the crisis was at its peak. Europe had already shelled out €100 billion to bailout Spanish banks but investors feared that Spain may need a sovereign bailout too. Borrowing costs for European governments soared to record highs and the euro was ruthlessly beaten down to near two-year lows of 1.20 against the US dollar and a 12-year low against the Japanese yen. The survival of the single currency was being questioned liberally by commentators and editorial writers.


 On 26 July 2012, almost exactly two years ago, Mario Draghi, the chief of the European Central Bank (ECB), stepped in and declared that the ECB is ready to do “whatever it takes” to preserve the euro. “And believe me, it will be enough,” he concluded.


Fast forward to 2014 and the jury is still out on whether the actions taken by the ECB have indeed been “enough” or is more needed.


Markets in Europe and elsewhere are reflecting a sense of calm induced by a heavy dose of unconventional monetary policy. This slush of liquidity has driven down borrowing costs across the region to record lows just two years after these countries were pushed to the wall by investors unwilling to hold debt issued by these countries. The benchmark 10-year bond yield in Greece has retreated from a high of 27.6% on 25 July 2012 to 6.2% on 22 July 2014. For Spain, yields have crashed from 7.3% to 2.5% over these two years, while borrowing costs for Italy have come down from 6.4% two years ago to 2.7% now. It is interesting to note that Spanish and Italian 10-year yields are now only marginally higher than that in the US, where the 10-year yield is at 2.45%.


The euro has survived and strengthened. So much so that on 14 July, ECB chief Draghi said that the stronger euro would present a “risk to the sustainability of the recovery”, reported the Associated Press.


But look away from the markets and signs of economic fragility are everywhere. Latest unemployment statistics released at the start of the month showed that unemployment in the region is at 11.6%, remaining close to the peak of 12%. Unemployment in Spain was at a staggering 25%. Growth and inflation indicators remain worrying too. The International Monetary Fund (IMF) estimates that growth in the euro zone will be a mere 1% in 2014, picking up to 1.5% in 2015. Meanwhile, inflation has remained low enough to keep fears of deflation alive. In June, euro zone inflation was reported at 0.5%, the ninth consecutive month that inflation remained well below the central bank’s target of 2%. Anything below 1% is considered “danger zone” by the ECB.


The result is that at a time when the US Federal Reserve is gradually trying to exit unconventional monetary policies, the ECB may be forced to do more. In June, the ECB became the first leading central bank to introduce negative deposit rates as a way to try and encourage banks to lend rather than hold on to their money. Other measures intended to improve credit flow in the economy were also announced and Draghi once again promised to consider more unconventional measures if inflation remains too low.


Which brings us to what next? The one thing that the ECB has stayed away from is traditional quantitative easing (QE) of the kind that the US Federal Reserve has undertaken and is now slowly unwinding. It’s an option, the ECB chief has admitted, but they are yet to press the trigger. As with all things economic, there are differing views. The Germans have historically opposed QE, but in recent writings the IMF seems to be pushing for it.


For the rest of the world including India, further easing from the ECB will have two implications. In the short term, if another global central bank embarks on large-scale liquidity injection, the supply of easy money continues. Emerging markets in general (India in particular) have benefited from strong foreign inflows into equity markets. At a time when India is trying to build its forex reserves, that supply (if managed well) doesn’t hurt. But in the long term, there will be repercussions. Reserve Bank of India governor Raghuram Rajan has gone to town saying that developed country central banks are not paying sufficient attention to the spillover effects that the unwinding of unconventional monetary policies can have on emerging economies. So whether it’s dealing with the wind down of QE from the US Federal Reserve this year and next, or dealing with the eventual withdrawal of monetary stimulus in Europe and Japan, there will be a price to pay somewhere down the road.


( Ira Dugal is assistant managing editor, Mint.)