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Nomura | UK Monthly Macro

20 February 2012

Euro area UK ThemeTheme
U U RE C O R E A IE C OA N D I C S A T E G S T R A T E G Y E K O ANOM CS NOM STR AND Y

ECB 3yr LTRO: Fixing what’s broken?
The monetary transmission mechanism is critically impaired but the ECB hopes the 3yr LTRO will help to fix what’s broken. We highlight what to watch out for in the months ahead.  Late in 2011, the ECB launched another round of non-standard policy measures including offering, for the first time, 3yr longer-term refinancing operations (LTRO). The policy aim was twofold: (1) to stem the signs of financial contagion; and (2) to improve the funding situation for the European banking sector and thereby help to restore the monetary transmission mechanism. We highlight a number of economic indicators (mainly money and credit data) which we think the ECB will be watching closely in the months ahead to gauge the effectiveness of its unconventional policy measures. Given the time lag in the data, we cannot yet draw firm conclusions on the effectiveness of the 3yr LTRO. And our “watch list” is certainly not “all inclusive”. Rather the chart pack illustrates, in our view, the key money and credit stories to follow. Clearly the ECB aims to prevent another credit crunch. The Q4 ECB Bank Lending Survey (BLS) shows a significant tightening in credit conditions in some countries (in France and in Italy in particular) but no tightening in Germany. But these BLS results are more about credit standards prior to the 3yr LTRO. The key test is whether the Q1 BLS shows improving conditions in France and in Italy. The ECB will also be watching whether money and credit volumes are declining more rapidly than implied by the current economic cycle. We highlight that credit cycles are already highly non-synchronised across the euro area: the periphery has firmly been in deleveraging mode over the past two years while credit growth in the core economies has remained fairly robust. Signs that the credit cycle in the core economies is turning south would be especially worrying for the ECB. The ECB also wants to restore the transmission mechanism. Tracking how bank lending and deposit rates move relative to funding rates provides a strong read on how “broken” the mechanism is now. We find that bank interest rates have increasingly delinked from money market rates, more so in Italy and in Spain. The key question is whether the ECB‟s policy measures will reverse this trend. But typically bank retail rates tend to react sluggishly to changes in market interest rates. The latest evidence suggests that bank interest rates now respond with even more sluggishness than before to policy rate cuts. So it may take longer before the full effect of the latest 50bp policy rate cuts can be seen in data. Assessing how the ECB judges the effectiveness of the December policy measures is a critical question in the months to come. If the ECB perceives the measures to be working, it is more likely to stick to its existing policy guns i.e. launch another round of bank liquidity injections – including even longer term refinancing operations- when and/or if the sovereign debt crisis starts to intensify again. But if the ECB concludes that the latest rounds of policy initiatives are doing little to restore the monetary transmission mechanism, the Bank is more likely to think completely outside the policy box when financial market turmoil requires yet another policy response. In this case, we think the ECB may re-consider the pros and cons of outright bond purchases and/or substantial policy rate cuts.

2 0 F E B R U AR Y 2 0 1 2

Jens Sondergaard
Senior European Economist +44 20 71021 969 jens.sondergaard@nomura.com

Lefteris Farmakis
European Rates Strategist +44 20 71039 242 lefteris.farmakis@nomura.com

Stella Wang
European Economist +44 20 71020 599 stella.wang@nomura.com

Nomura International plc See Disclosure Appendix A1 for the Analyst Certification and Other Important Disclosures

Nomura | Euro area Theme 20 February 2012 Contents Monetary transmission in good times…and in bad! The main tool in the ECB toolbox has been liquidity Credit conditions are tightening but not everywhere Narrow money is growing at different speeds Credit cycles are not synchronised across the euro area Deposit rates are increasingly delinked from market rates Bank lending rates are affected by sovereign debt crisis Has interest pass-through declined? Where is the ECB heading after the 3yr LTRO? Private sector lending (excluding financial sector) in euro-area countries Bibliography 3 4 5 6 7 8 9 10 11 12 14 2 .

. The ECB sets the policy rate and supports the money markets by providing liquidity and holding deposits from the banking system. the pressure on bank balance sheets can be severe. To the extent that the policy rate boosts activity.. .. Figure 1a.. the side-effect of having a two-tier banking system – as we will demonstrate below – (composed of banks addicted to ECB funding alongside well-functioning ones able to borrow and lending in the interbank money markets) is that it leaves the monetary transmission mechanism significantly impaired. The bottom line is that with a well-functioning transmission mechanism. households and firms are more inclined to increase consumption and investment than to increase savings. a rate cut by the ECB should trigger a tick up in money (i. demand for credit should increase as well. 3 . The ECB has responded to the dislocations on the money markets with a set of liquidity operations which have. Normal monetary transmission mechanism The banking system plays a critical role in the monetary transmission channel The two key channels are the interest rate and the bank lending channel The bank lending channel links policy rate changes with deposit flows There are increasing signs that the interest rate and bank lending channels are impaired. But in normal times the level of ECB liquidity support is minimal as banks are able to lend and borrow funds via the interbank money markets. albeit less direct. deposits) and credit growth. As Figure 1(b) shows. While having ECB liquidity available is clearly preferable to the case of no ECB liquidity. an ECB rate cut will lower the cost of interbank lending and borrowing. preventing banks from expanding the supply of credit.g. The bank lending channel. deposit flows will increase as well (as bank lending eventually ends up as deposits within the banking system). if some banks are unable to access the interbank markets. made the Bank the lender of first resort for many European banks. And when banks are shut out of the money markets. the interest rate and the bank lending channel can break down. lower policy rates lead to a rise in government bond prices and loan valuations). As money market rates decline. The idea is that a policy rate cut boosts the value of the asset side of a bank balance sheet (e. As banks increase their lending to borrowers. Basically. which will enable banks to increase overall lending. Monetary transmission in good times…and in bad! There are number of ways an ECB rate cut is transmitted to the real economy.despite the ECB having made liquidity available to the banking sector since 2008 Figure 1b. Broken monetary transmission mechanism ECB Official interest rate Interest rate channel Bank A Deposit Loan Money market rates ECB Loan Deposit Official interest rate Interest rate channel MROs and LTROs Deposit Loans Deposit Bank lending channel Bank B Bank lending channel Bank A Loan Loans Loan Bank B Loan Deposit Money market rates Retail rates Retail rates Deposit outflow Non financial firms Households Non financial firms Households Source: Nomura Global Economics. and the value of the euro may decline. there are increasing signs that the transmission mechanism has become more and more impaired within the euro area and more so in some countries.e. However.Nomura | Euro area Theme 20 February 2012 1. works in tandem with the interest rate channel and can amplify the effects of a policy rate cut. In a normal functioning money market. Faced with lower lending and deposit rates. they are forced into asset fire sales. banks will lower their retail rates on loans and deposits (the interest rate channel). as we demonstrate below. in effect. there are two key channels at work: the interest rate channel and the bank lending channel: Figure 1(a) illustrates how the two channels work in normal times. Here we focus on the role played by the European banking system in transmitting a policy rate cut to the real economy. Source: Nomura Global Economics. Markets may revise their expectations of future policy rates down. stock markets may rally.

4 1. The ECB responded again by injecting more liquidity into the system through its 3yr refinancing operations announced at the December meeting.0 2.5 3. The European sovereign debt crisis caused the re-emergence of heightened banking sector concerns. The main tool in the ECB toolbox has been liquidity When it became clear that money markets were becoming increasingly dislocated in September 2008.4 0. Figure 2. with EONIA currently hovering around 40bp (Figure 2). with the core banks enjoying uninhibited market access and periphery banks largely cut off from money markets. Euribor remains a reference rate that can be used to gauge aggregate credit risk in the banking sector. Ireland and Portugal) remain cut off from the funding markets and rely exclusively on central bank funding. euro-area money markets are still a two-tier market.5 2.. Consequently. Money market rates Figure 3. This is evidenced by the drop in the Euribor-OIS spread.2 1. Low money market rates and ample liquidity provision by the central bank went a long way towards easing funding tensions in the money markets in 2008.6 Euribor-OIS spread (rhs) 1.0 4. It is worth noting.5 1.but a large share of European banks remains addicted to ECB funding % 5.8 % of all extraordinary funding (ECB+ELA) 100 Periphery Countries (GIIPS) Rest of EMU 80 60 40 1. One of the main consequences of the sovereign debt crisis has been the exclusion of most periphery banks from funding markets due to their idiosyncratic relationship with the stressed periphery sovereigns.Nomura | Euro area Theme 20 February 2012 2.2 0. This is highlighted by the sharp rise in the share of extraordinary funding (ECB plus ELA) for banks in the periphery vs.0 20 0 May-09 Nov-09 May-10 Nov-10 May-11 Nov-11 Source: Datastream and Nomura Global Economics. when the spread between Euribor-OIS reached three-year highs.. Since then. Despite the fact that the volume of uncollateralised lending between banks has shrunk significantly since the global financial crisis.8 4.5 0.0 0.0 1. Use of extraordinary funding (ECB plus ELA) The ECB has become the main provider of liquidity in the European banking system The Euribor-OIS spread is one indicator of systemic credit risk in the banking system The Euribor-OIS spread has declined in 2012. money market rates have started to re-normalise. This limitation further mitigates the positive impact of December‟s 3yr LTRO for the programme countries. This decision led to significant amounts of excess liquidity in the banking system and has caused money market interest rates to fall well below the main refinancing rate.0 1.0 Jan 08 Jan 09 Jan 10 Jan 11 Jan 12 0. Most of the banks in the European periphery (especially in Greece. after the ECB‟s emergency rate cuts.0 3.0 0. for the three countries under IMF programmes there is a limit to the amount of central bank funding that domestic banks can tap. those in core countries (Figure 3).5 ECB policy rate (lhs) EONIA (lhs) % 2. the ECB responded by taking on the role of the main provider of liquidity to the European banking system. Source: Datasream and Nomura Global Economics. The concrete change in ECB operations was the decision to conduct regular refinancing operations at full allotment (a technical term which basically says that banks can take whatever amount of liquidity they want from the ECB as long as they can post sufficient collateral).. initially during the first phase of the Greek crisis in May 2010 and then as the crisis escalated around Italy in November 2011..6 0. one indicator of systemic credit risk in the banking system. Furthermore. 4 . Despite the positive impact of those measures. however. the European money market has far from normalised. . Euribor is the rate for 3m uncollateralised interbank lending and OIS refers to a 3m swap contract whereby one exchanges EONIA (floating leg) for the 3m OIS rate (fixed leg). that not all European banks currently share these benefits. Bottom line: The ECB has responded both to the global financial crisis and to the sovereign debt crisis with large liquidity injections.

This recent divergence between Germany and France is interesting as changes in credit standards in those two countries had been fairly synchronised until the middle of 2011 (Figure 4). Banco de Espana and Nomura Global Economics. Bottom line: Credit standards have started to diverge across the larger countries in the euro area. It also records the senior loan officers‟ evaluation of the conditions affecting credit demand. We think the ECB will look carefully at the results of the Q1 BLS (out on 25 April 2012) to properly assess the effectiveness of the LTRO. Credit conditions are tightening but not everywhere The ECB is hoping that its December 2011 round of unconventional measures will fend off a serious credit crunch across the euro area. But it is also important to realise that the BLS results are more about the credit conditions prior to the December 3yr LTRO. Banco de Espana and Nomura Global Economics. To assess whether the 3yr LTRO has averted a credit crunch. Bank lending survey – loan supply Figure 5.Nomura | Euro area Theme 20 February 2012 3. -80 Spain -100 4Q02 1Q04 2Q05 3Q06 4Q07 1Q09 2Q10 3Q11 Source: ECB.amid signs that credit standards tightened markedly in Italy and France in Q4 The ECB hopes to prevent another credit crunch. The survey offers an assessment of credit standards for approving loans as well as credit terms and conditions applied to enterprises and households. In contrast. The survey is addressed to senior loan officers of a representative sample of euro-area banks and is conducted on a quarterly basis. Bank lending survey – demand for loans %. One way to assess whether euro-area-wide credit conditions are tightening is to look at the results of the ECB‟s bank lending survey. But the results of the Q4 Bank Lending Survey reflect mainly the conditions prior to the ECB December intervention. The most recent BLS also showed that demand for loans had declined in Q4. The results of the ECB Bank Lending Survey (published on 1 February 2012) were widely reported. Overall. Figure 4. 5 . Q1 BLS results remain key . Net percentage 80 Italy France tightening 60 40 60 40 20 Germany Spain 20 0 -20 -40 -60 Italy France Germany 0 -20 -40 4Q02 1Q04 2Q05 3Q06 4Q07 1Q09 2Q10 3Q11 Source: ECB. Bundesbank. To the extent that French banks were more adversely affected than German banks by the contagion from the sovereign debt crisis. Net percentage 100 80 %. the results of the Q4 BLS confirm signs of a credit crunch at the end of 2011.. In particular. European banks significantly tightened credit standards for both households and corporates in Q4. Bundesbank. the results of the Q1 2012 BLS will be very significant. The survey also attributed tighter credit standards to the sovereign debt crisis impairing banks‟ balance sheets and making it harder for banks to access wholesale funding. the divergence is perhaps not surprising... Credit standards tightened very markedly in Italy but also in France.. Banks in Italy and France reported a marked tightening in credit conditions in Q4 2011. Banca d‟Italia. Banca d‟Italia. But results in Q4 BLS say little about effects of 3yr LTRO. household demand for housing loans weakened significantly. Italian and French banks in particular saw weaker demand for bank lending (Figure 5). mainly reflecting greater uncertainty around housing market prospects and poor consumer confidence. A key test will be whether banks in France and Italy have stopped tightening credit standards. Looking at how credit conditions have evolved at the country-level illustrates some interesting divergences especially in H2 2011. German banks reported no tightening in credit standards in both Q3 and Q4 2011. Banque de France. Banque de France.

This growth dispersion has persisted since the onset of the 2008-09 financial crisis. Box 2. When households and firms are becoming more optimistic about future economic conditions. they would want to hold a greater share of their wealth in very liquid assets. This reflects banks‟ desire to close their funding gaps by relying more on stable. 6 . households and firms can use their deposit funds to pay for consumption and investment goods. We are also seeing some movement of household funds from short-term to longer-term deposits across the euro-area banking system (Figure 7). The ECB‟s monetary analysis focuses on M1 growth – also known as “narrow money” and defined as the sum of currency in circulation and overnight deposits – and the broader M3 growth as signals for future inflationary pressures. For instance. The ECB finds that uncertainty had a “significant impact on monthly M1 growth in August and September 2011” as households and firms shifted funds into overnight deposits (see ECB Monthly Bulletin. Aside from transaction purposes. Italy and Spain. Source: ECB and Nomura Global Economics. BE) Periphery (GR. Household deposits with agreed maturity growth Monetarist economics is back in vogue. The intuition is that growing monetary balances will eventually be associated with higher consumption/investment and in turn higher inflation. IR) % y-o-y 30 25 15 10 5 20 15 10 5 0 -5 -10 0 -5 -10 -15 Q1 2003 -15 -20 Q1 2005 Q1 2007 Q1 2009 Q1 2011 -25 Dec-03 Over 2 years Over 1 and up to 2 years Up to 1 year Total deposits with agreed maturity Jun-05 Dec-06 Jun-08 Dec-09 Jun-11 Note: The M1 series is deflated by the GDP deflator Source: ECB and Nomura Global Economics. But household and firm deposit growth is also an important leading indicator of future economic activity. as elevated uncertainty may induce households to shift their portfolio away from illiquid and towards more liquid assets. households and firms may also choose to hold deposits for precautionary reasons. Real M1 growth rates dispersion in Euro area Figure 7. A rise in overnight deposits may indicate better activity data ahead. we are watching deposit growth Real M1 growth is now uneven across countries. Figure 6. PT. But it is also possible that narrow money growth has increased because of higher risk aversion. Figure 6 shows real M1 growth for three different euro-area country groupings. But narrow money is not growing in the country grouping consisting of Belgium. The uncertainty shock in H2 2011 may have affected M1 growth We are keeping track of a compositional shift within M1: longer-term deposits are up % y-o-y 20 Core (GE. Bottom line: Narrow money is growing at different speeds across the euro area. real M1 growth was fairly uniform across the euro area.Nomura | Euro area Theme 20 February 2012 4. The latter is not surprising as large deposit outflows currently seen from the periphery banks reflect a lack of confidence in the banks there. Robust deposit growth in the rest of the euro area may reflect consumer and firm expectations of future economic activity. The most recent data show a mixed picture across the euro area: narrow money continues to exhibit stable growth in Germany and France. SP. the money is not accessible to spend on consumption. Narrow money is growing at different speeds Monitoring monetary aggregates provides important information about the shocks that are hitting the economy. FR) Semi-core (IT. deposit flows in and out of the banking system may signal funding tensions among banks. January 2012). longer-term retail deposits. If households are increasingly locking up their assets for a longer time. This shift in the composition of bank funding has implications for the short-term demand outlook. Prior to the 2008-09 financial crisis. But growth divergences started appearing from Q3 2008 onwards and have persisted until today. This increased demand for liquid assets is motivated by transaction purposes: as the economic recovery takes hold. Greece and Portugal). And it is outright declining in the three IMF/EU programme countries (Ireland.

e. In contrast. Non-financial private sector loans Figure 9. Households use banks for mortgage finance and unsecured borrowing. 2011). the credit cycle has not been synchronised across the euro area. Hence.Nomura | Euro area Theme 20 February 2012 5. Household unsecured borrowing (i. Figure 9 shows how consumer credit prior to 2008 was mainly driven by strong credit growth in the periphery and in the semi-core countries. IT) Core (GE. with credit growth hardly turning negative (Figure 8). FR) Euro area May-06 Jan-08 Sep-09 May-11 Source: ECB and Nomura Global Economics. bank lending to households and firms is a critical part of the monetary transmission mechanism. Consumer credit % y-o-y 25 20 Core (GE. PT. Portugal and Greece). During 2010. SP. Credit growth picked up during 2010 but then slowed recently. The intuition is clear: rapid lending growth boosts economic activity as funds are available to increase consumption and investment. households in France and Germany have continued to increase their consumer debt through November 2011. Deleveraging has been very limited in France and Germany. -2 -4 -6 Sep-04 Semi-core (BE. SP. the credit cycle gradually turned and lending growth turned positive again. The bottom line: The non-synchronised credit cycles across the euro area are problematic for the ECB: There are countries which clearly require a loose monetary policy stance to offset the deflationary impacts of deleveraging (Ireland. Credit growth turned negative in July 2009 and has remained so ever since (Figure 16b). IR) -5 -10 -15 Jan-04 Mar-05 May-06 Jul-07 Sep-08 Nov-09 Jan-11 Source: ECB and Nomura Global Economics. Most recent data point to year-on-year credit growth in those two countries of between 2% and 4% (see Figure 16a). But looser monetary policy may also postpone the deleveraging process which is necessary in some countries (Spain). The latest data (December 2011) point to households reducing consumer debt in those countries too. consumer credit) offers more signs that the credit cycle is unsynchronised across the euro area. Credit cycles are not synchronised across the euro area Households and firms are highly dependent on the availability of bank lending in the euro area. But there are no signs of the credit cycle turning in the three IMF/EU programme countries. IT) Periphery (GR. Speeds of deleveraging vary greatly across the euro area Bank lending is a critical part of the monetary transmission mechanism We are watching for turning points in household unsecured borrowing Non-synchronised credit cycles are problematic for the ECB Figure 8. But unsecured borrowing has been declining since mid-2008 mainly reflecting deleveraging in the periphery as well as in the semi-core. FR) Semi-core (BE. In contrast. households and firms continue to deleverage at a rapid pace (Figure 8). A turning point in these series gives a good indication of whether households are becoming more or less willing to increase spending on consumer durable goods. The Estonia credit cycle is an example of a very persistent and severe spell of deleveraging. And keeping monetary policy loose for too long may fuel excessive credit growth in other countries (Germany) leading to the build up of unsustainable private sector imbalances. With annual credit growth at -10%. However. PT. IR) % y-o-y 8 6 15 10 5 4 2 0 0 Periphery (GR. We have empirical evidence that credit growth is positively correlated with GDP growth. times of deleveraging are usually associated with low or negative activity growth as households and firms focus on debt repayment rather than consuming and investing. The pace of deleveraging has also been quite muted in Italy and Belgium (Figures 16a and 16b). especially in the euro area (see Zhu. 7 . Firms – in particular small and medium-sized firms – rely almost exclusively on bank lending as a source of external funding. Non-bank private sector credit growth grew very strongly up to the start of the 2008-09 financial crisis and then declined sharply.

The key point from Figure 10 is that deposit rates increased in a synchronised fashion as the ECB tightened monetary policy during its tightening cycle of 2005-08... Hence. Prior to the crisis. . Bottom line: Euro area deposit rates are increasingly delinked from money market rates. the interest rate on new deposits has held steadier in Spain.10 0.. If money markets were functioning normally. 2011).35 0.Nomura | Euro area Theme 20 February 2012 6. Italian banks have been fighting aggressively for household deposits in H2 2011 and the 2year retail deposit rate increased sharply in November and again in December.. Figure 11 shows how cross-country dispersion of household deposit rates has evolved. In contrast.05 0. the retail deposit rate is the marginal rate of savings. Portuguese deposit rates have also risen sharply since July 2010. These level differences can reflect heterogeneity in the savings products offered. Deposit rates are increasingly delinked from market rates The effectiveness of monetary policy hinges on how changes in money market rates affect retail bank interest rates. Figure 10. the new set of rules requires Spanish banks that want to offer deposit rates above a certain threshold to contribute more to a deposit guarantee fund. Here we look at how retail deposit rates have evolved both prior to and after the onset of the financial crisis in 2008. Note: Deposits – household deposits with agreed maturity Source: ECB and Nomura Global Economics.30 0. the money market rate would determine the floor for funding in the wholesale funding markets. But rates have started diverging from September 2008 onward. This may reflect Banco de Portugal‟s recent measures. deposit rates should follow closely money market rates. But from a saver‟s point of view.25 Jan03-Sep08 Sep08-Dec11 0.with Italian deposit rates increasing very sharply in November and December % 6 5 4 3 2 1 EURIBOR 3mth Germany Spain France Greece Ireland Italy Portugal % 0.20 0. From a bank‟s point of view. regulatory differences or even differences in deposit insurance schemes. But we believe this reflects the government‟s move in June 2011 to end the “price war for deposits”. The level of retail deposit rates obviously varies across countries: French deposit rates were at the same levels as those in Greece in 2003. Household deposit (up to 2 years maturity) rates Figure 11.15 0. To incentivise households to lock their deposits away for an extended period of time. in normal times. 8 . the retail deposit rate represents the marginal cost of funding via the retail deposit market. If banks increase deposit rates.00 Total Up to 1 year Over 1 year Over 2 years and up to 2 years 0 Jan-03 Jul-04 Jan-06 Jul-07 Jan-09 Jul-10 Source: ECB and Nomura Global Economics. Italian retail deposit rates used to be the lowest in our sample. it becomes attractive to save and more households will save more and postpone consumption. banks have to increase their deposit rates. Rate dispersion are generally now greater than before the Lehman Brothers collapse. We are seeing signs of this happening and more so in some countries than in others. 3-month EURIBOR was the market rate most correlated with this particular deposit product (see Bondt (2005)). But rates have increased much less over the past two months. Deposit rate cross-country variation coefficient Banks are offering higher deposit rates in their search for longer-term deposits Bank retail deposit rates are now diverging across countries. Figure 10 compares interest rates on new retail deposits of 2-year maturity offered to households with the 3-month EURIBOR rate. which impose stricter own funds requirements on those institutions offering deposit rates above a certain threshold (see link for details). According to Bloomberg (June 3.

containing also contagion. .16 0.04 0. And Italian and Spanish banks have increased their interest rates by respectively 164bp and 198bp since the middle of 2010.08 0. A decline in the cost of new borrowing makes households and firms more inclined to take on new loans. Source: ECB and Nomura Global Economics.Nomura | Euro area Theme 20 February 2012 7.00 0 Jan-03 Total Jul-04 Jan-06 Jul-07 Jan-09 Jul-10 Up to and Over EUR 1 million including EUR 1 million Note: Lending rates for loans up to €1 million Source: ECB and Nomura Global Economics. commercial banks across the euro area did not lower their lending rates by as much. 9 . The key test of the ECB‟s December policy measures would be if cross-country dispersion of lending rates decreased. 1 April 2011) that link increasingly broke down from the summer of 2007 onwards when the financial crisis intensified. The reason was that the tightening in credit conditions was associated with an increase in the relative price of bank credit. although it should be recognised that the transmission mechanism remains severely disrupted in some euro area countries” Bottom line: Tracking how bank lending rates move relative to market funding rates provides a strong read on how “broken” the monetary transmission mechanism currently is. aggregate demand and economic activity should increase as a result. new business.18 0. the spread between the rate on new lending and the money market rate widened substantially. So it appears that bank interest rates on NFC loans have increasingly delinked from money market rates. In contrast. Note: Loans .. As a result. Figure 12 shows that bank lending rates have evolved quite differently in the past two years: German banks have not changed the interest rates they charge on new corporate lending significantly. The interest rate on new short-term corporate lending has historically tracked the 12m EURIBOR rate closely (see Bondt.06 0. This was acknowledged by ECB VicePresident Constancio in a recent speech (see link): “If we look at the past experience..signalling that the monetary transmission mechanism is broken Cross-country dispersion of bank lending rates remains very high. then it looks to have become even more broken as the sovereign debt crisis intensified during 2011. 2005).up to 1 year maturity. triggering a decline in the 12m EURIBOR. NFC loan rates cross-country variation coefficient % 9 8 7 6 EURIBOR 12mth Spain Ireland Portugal Germany France Italy % 0. Corporate bank lending rates have traditionally tracked 12m EURIBOR rates Spread between bank lending and money market rates has remained elevated since 2008 Spanish and Italian lending rates have increased markedly since mid-2010 Figure 12. And as the ECB was cutting its policy rates sharply..10 5 4 3 2 1 0. NFC new business (up to 1 year) lending rates Figure 13.02 0. If the monetary transmission mechanism was broken before the first Greek bailout. This is apparent in the IMF/EC programme countries (we are only able to show data for Portugal) but also increasingly so in Italy and in Spain. But as described previously (see Europe Round Up: Passing Through.12 0.14 Jan03-Sep08 Sep08-Dec11 0. the price of a similar loan in Portugal has increased by 245bp. There is evidence that the cross-country dispersion in NFC lending rates has increased sharply from September 2008 onwards (Figure 13).. Bank lending rates are affected by sovereign debt crisis The effectiveness of monetary policy also hinges on whether changes in the money market rate transmit into changes in the rates on new bank loans. To the extent that the new borrowing is used to finance consumption and/or investment. the ECB’s measures have enabled the monetary policy transmission mechanism to continue operating relatively well at the level of the euro area.

To understand the latest developments.39(0) 0. The main findings are shown in Figure 14. see Europe Roundup: Contagion Fears. Obviously. we can run our model with rolling-window samples of 36 months.19(0) 0. Bank lending rates now react more sluggishly to policy rate changes than before. it doesn‟t appear that the interest rate channel has improved since 2008.05(3) 0. Figure 15 shows that.which indicates that the interest rate channel is not functioning properly Figure 14.06(2) 0.. Second. while “A” is the after-crisis period starting from 2009M05. house mmkt purchase loans and non-financial corporate loans (NFC)) and Δrt refers to EONIA.3 GE P A FR P A IT P A SP P A 0. the challenge for the ECB is to find a way to heal the interest rate channel. Obviously.02(5) 0.04(2) 0.. To formally test whether this is the case. “P” refers to the pre-crisis period of 2003M01 – 2007M08. In contrast. interest pass-through appears to have increased in Germany.05(3) 0. Has interest pass-through declined? The interest rate channel constitutes a key part of the monetary transmission mechanism.09(2) 0.07(7) 0. All data are monthly.24(2) 0.09(0) 0. In sum. The spread between lending and money market rates increased significantly during Q4 2008 and has remained elevated since then (for details.05(3) 0... . the stronger the contemporaneous impact that changes in EONIA have on lending retail rates. The spread between the bank retail lending rates and money market rates gives us one possible read as to how the interest rate channel is operating. relative to the pre-crisis period.e.03(6) 0. Regardless.11(0) 0.2 0.16(0) 0.1 Coefficents are insignificant Jul-09 Jan-10 Jul-10 Jan-11 Jul-11 0.17(0) 0.28(0) 0.3 0. especially in the euro area where banks play a central role in financing the real economy.14(0) 0. Note: 1. The two-digit number denotes the estimates of β in our impact model while the numbers in parentheses show the number of significant lags of ∆rmmkt .0 Jan-09 0. β.19(0) 0.13(2) 0. Comparing the effects of money market rates on lending rates pre and after crisis Figure 15. 2. it is possible that absent the ECB policy measures.13). the overnight euro-area money market rate.04(6) 0.17(0) 0. among the four biggest economies this decline appears to reflect Spanish developments in particular (the pass-through coefficient on Spanish total loans dropped from 0. Bottom line: We interpret the results as evidence that the euro area‟s interest rate channel is not functioning properly. the ECB introduced a set of nonstandard measures to help support the interest rate channel.5 EA P A Consumer credit 0.04(5) 0. Note: The rolling window is for samples of 36 months.19(0) 0. First.2 0. we assume the following relationship between money market rates and lending rates: Δrt retail retail Level of interest rate spread indicates whether interest rate channel is working = α + β Δrt mmkt + εt where rt refers to retail lending rates (i.25(0) 0. lending rates on consumer credit loans.11(0) 0. the interest rate channel may have been even more impaired by now. Since the onset of financial turmoil in September 2008. the degree of interest pass-through has declined across the euro area (the estimates of the passthrough coefficient were higher in the pre-crisis era than in the post-crisis).17 to 0. This suggests that the interest rate channel is less effective now than it previously was.14(2) Total loan 0.1 House purchase loan (lhs) Consumer credit (lhs) Loans to NFCs (rhs) 0.10(3) - House purchase 0. 10 . Source: Datastream and Nomura Global Economics.08(0) 0. 18 November 2011). a worrying conclusion given the myriad ECB unconventional policy interventions in that period. since 2009 there has been a clear downward trend in the value of β for all types of retail lending rates.26(0) 0. X-axis represents the end point of the respective regression windows.0 Source: Datastream and Nomura Global Economics.03(3) 0.4 0.13(0) 0. the bigger the coefficient.Nomura | Euro area Theme 20 February 2012 8. Euro-area rolling window estimates of the impacts of changes in money market rates to bank lending rates 0.11(3) Loans to NFC 0.07(3) 0.

new policy tools are needed 11 . If the ECB perceives the measures to be working. So even though the ECB‟s liquidity operations.. the Bank is more likely to think completely outside the policy box when financial market turmoil requires yet another policy response. Germany probably does not The litmus test will be if looser monetary conditions do transmit to the real economy If the ECB perceives measures to be successful. The ECB‟s problem is that the monetary transmission mechanism impairment is really an unfortunate bi-product of the sovereign debt crisis. In this case.75% has. the ECB will keep the policy rate at 1% throughout 2012. Bank retail lending and deposit rates for households – the interest rates that really affect the monetary stance – have increased significantly in some countries (Italy in particular) in the past six months while they have remained unchanged in the core countries (see Figures 10 and 12). the asset price movements after the ECB 3yr LTRO do look similar to those following QE announcements by the Fed and the BoE. which really kicked off in earnest in H2 2011. The ECB may not be doing QE but it appears to have engineered QE-type effects The euro area needs further monetary loosening. The negative feedback loop between banks and the European sovereigns. While our European Rates Strategy team has pointed out several reasons why this LTRO rally may not last (see European Rates Insights: 36-month LTROs: A pyrrhic victory?. it is more likely to stick to its existing policy guns. expect more bank liquidity measures But if the transmission mechanism remains broken. there are tentative signs that the December 3yr LTRO has stopped and partly reversed the adverse feedback loop. yield curves have shifted down across the maturity spectrum (including in Spain and in Italy) and bank equity prices have risen. Assessing how the ECB judges the effectiveness of the December policy measures is a critical question in the months to come. This means that if the sovereign debt crisis starts to intensify again. needs to be stopped and even reversed if monetary conditions are to start loosening in the countries most in need of a looser monetary policy.Nomura | Euro area Theme 20 February 2012 9. So it is clear that countries like Spain and Italy need looser monetary policy while Germany probably does not. That said. Bank funding costs have stopped rising in 2012... 9 February 2012). we think the ECB may reconsider the pros and cons of outright bond purchases combined with substantial policy rate cuts. It is possible that if data continue to improve and if the Greek PSI process remains on track. in our view. cannot be categorised as a proper Fed/BoE-style quantitative easing operation. But whether the ECB policy rate is at 1% or 0. it remains to be seen to what extent the looser monetary conditions are transmitting to the real economy including money and credit. But after the February ECB meeting. only a marginal bearing on the forecast. the ECB may launch another round of bank liquidity injections – including even longer term refinancing operations. 24 January 2012). Where is the ECB heading after the 3yr LTRO? To be clear. The ECB may not be doing QE-proper but the policy intervention appears to have engineered QE-type effects. what matters for the ECB‟s current and future monetary policy stance is that yields have so far declined across the maturity spectrum and financial and monetary conditions are now looser than they would have been absent the 3yr LTRO.but whether the policy rate is 1% or 0. We have highlighted a number of economic indicators (mainly money and credit data) which we think the ECB will be watching closely in the months ahead to gauge the policy effectiveness of its unconventional policy measures. But if the ECB concludes that the latest rounds of policy initiatives do little to restore the monetary transmission mechanism.75% has marginal bearing on outlook Italy and Spain need looser monetary policy. we think the euro area needs further monetary stimulus in the months ahead and expect the ECB to lower the policy rate by a further 25bp at the March meeting. . The critical question is to what extent the set of unconventional measures launched in December are helping to mend the monetary transmission mechanism across the euro area. we are less confident now that the ECB will actually deliver another rate cut (see Euro area Comment: ECB: Another cut coming? We are less sure now.. Looking at asset prices since January. strictly speaking.

Source: ECB and Nomura Global Economics. Italy % y-o-y 25 20 15 10 5 0 -5 -10 Jan-04 House purchases Consumption NFC Netherlands % y-o-y 25 20 15 10 5 0 -5 -10 Jan-04 House purchases Consumption NFC Jul-05 Jan-07 Jul-08 Jan-10 Jul-11 Jul-05 Jan-07 Jul-08 Jan-10 Jul-11 Source: ECB and Nomura Global Economics. 12 . France % y-o-y 20 House purchases Consumption Spain % y-o-y 40 House purchases 30 20 NFC 15 Consumption NFC 10 10 5 0 0 -10 -20 Jan-04 -5 Jan-04 Jul-05 Jan-07 Jul-08 Jan-10 Jul-11 Jul-05 Jan-07 Jul-08 Jan-10 Jul-11 Source: ECB and Nomura Global Economics.Nomura | Euro area Theme 20 February 2012 Figure 16a: Private sector lending (excluding financial sector) in euro-area countries Euro area % y-o-y 16 14 House purchases Consumption Germany % y-o-y 14 12 House purchases Consumption NFC 12 10 8 10 8 6 NFC 6 4 2 4 2 0 0 -2 -4 Jan-04 Jul-05 Jan-07 Jul-08 Jan-10 Jul-11 -2 -4 -6 Jan-04 Jul-05 Jan-07 Jul-08 Jan-10 Jul-11 Source: ECB and Nomura Global Economics. Source: ECB and Nomura Global Economics. Source: ECB and Nomura Global Economics.

Estonia % y-o-y 120 100 80 House purchases Consumption NFC Austria % y-o-y 20 House purchases Consumption NFC 15 10 60 5 40 20 0 -20 Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10 Jan-11 0 -5 -10 Jan-04 Jul-05 Jan-07 Jul-08 Jan-10 Jul-11 Source: ECB. Source: ECB and Nomura Global Economics. Source: ECB and Nomura Global Economics. Bank of Estonia and Nomura Global Economics. Source: ECB and Nomura Global Economics. Ireland % y-o-y 40 30 20 10 0 -10 -20 -30 Jan-04 House purchases Consumption Belgium % y-o-y 30 20 10 0 -10 -20 -30 -40 Jan-04 House purchases Consumption NFC NFC Jul-05 Jan-07 Jul-08 Jan-10 Jul-11 Jul-05 Jan-07 Jul-08 Jan-10 Jul-11 Source: ECB and Nomura Global Economics. 13 .Nomura | Euro area Theme 20 February 2012 Figure 16b: Private sector lending (excluding financial sector) in euro-area countries Greece % y-o-y 40 Portugal % y-o-y House purchases Consumption House purchases 20 Consumption NFC 30 20 NFC 15 10 10 0 -10 -20 Jan-04 5 0 -5 -10 Jan-04 Jul-05 Jan-07 Jul-08 Jan-10 Jul-11 Jul-05 Jan-07 Jul-08 Jan-10 Jul-11 Source: ECB and Nomura Global Economics.

Box 2. curse. IMF Working Paper. Claudio Borio and Piti Disyatat (2009). de Bondt (2005). (Link) Recent Nomura Publications on the ECB stance: Euro area Comment: Another cut coming? We are less sure now. Credit and business cycles: some stylized facts. 6. January 2012 (Link). Bank of International Settlements Working Draft. 13 January 2012 (Link) 14 .Nomura | Euro area Theme 20 February 2012 Bibliography Gabe J. 2 February 2012 (Link) Europe Roundup: ECB: In a holding pattern. WP/09/163. 9 February 2012. (Link) Feng Zhu (2011). (Link) ECB Watch: Implicit Signals. (Link) “Money Growth and Uncertainty”. 1. Bank of International Settlesments Working Paper No 292. Andre Meier (2009). or non-event? Unconventional monetary policy in the United Kingdom. ECB Monthly Bulletin. Unconventional monetary policies: an appraisal. German Economic Review. “Interest rate pass-through: empirical results for the euro area”. 7 February 2012 (Link) Europe Roundup: ECB: More time to digest. Panacea. 37-78.

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