Draghi still searching for ‘bazooka’

The consensus view is that the ECB will keep the main interest rate on hold today, but its president Mario Draghi may signal the he is looking at unconventional ways of boosting lending to the wider economy.

There is a compelling argument for introducing a rate cut at today’s meeting. Inflation remains subdued and economic activity, particularly bank lending, is stuck at stubbornly low levels. But Mr Draghi has noted on several occasions that the European banking system remains fragmented.

“The ECB’s main concern is not the absolute level of its policy rate but the continued fragmentation of bank lending rates, particularly for SMEs. However, up to now, the ECB has not been able to come up with a technically — and politically — acceptable bazooka to boost lending to SMEs. In fact, when assessing possible policy options to stimulate the economy, the ECB faces a new dilemma: choosing a rather ineffective but politically acceptable rate cut or an effective but politically controversial lending bazooka,” says Carsten Brzeski, an economist with ING bank in Brussels.

The resolution of the Cyprus bank crisis has added to ECB’s dilemma. Depositors over €100,000 are going to be ‘bailed in’ to the region of 60%. This will lead to higher deposit costs and higher lending costs among periphery states.

If this were to happen, then a reduction in the ECB interest rate would do little to enhance the transmission of credit in the region. Moreover, there would be an even bigger fragmentation in the financial sector.

“Unfortunately, if the ECB really wants to provide a bazooka for the real economy, it would have to cross yet another Rubicon.

“To kick-start lending to SMEs, the ECB would either have to provide further direct relief to the banks or buy bundled-up SME loans.

“Such a move, however, would be hard to sell politically as core Eurozone countries could regard it has recapitalisation of peripheral banks through the back door,” adds Mr Brzeski

“A rate cut would do little to stimulate economic activity. However, eventually, it might be easier to sell a rate cut within the ECB’s Governing Council and to the outside world than a lending bazooka for SMEs.

“At the current juncture, the ECB is caught on a fragile tightrope walk: on the one hand, the ECB does not believe in the curative impact of a rate cut but, on the other hand, it has not yet come up with a politically acceptable solution for the SME funding problem. If the recovery fails to unfold, the ECB will have to choose at least for one side.”