July 12, 2012

Europe Tries Sticks, Carrots in Battling Crisis

Spain given more time to cut debt; ECB sees overnight deposits drop on rate cut

The ECB headquarters in Frankfurt. (Photo: AP) The ECB headquarters in Frankfurt. (Photo: AP)

The eurozone is trying to combine rewards with punishments as it seeks to thwart a stubborn debt crisis that has embroiled the region for the past few years. In their approach to Spain, political leaders offered Madrid an extra year to get its budget under control provided it enacted additional budget cuts—which Prime Minister Mariano Rajoy has already begun to do. And the European Central Bank (ECB) has seen overnight deposits plummet after a decision to slash interest rates to zero—forcing banks to at least consider lending to one another if they want to make any money on stashed cash.

Bloomberg reported Thursday that leaders’ approach to a bailout of Spain’s banking sector included not just the longer grace period but also Rajoy’s response, which included unpopular cuts to budgets and higher taxes. Other conditions attached to the deal, which offers the possibility that Spanish bonds will be bought up to keep yields down, include the transfer of powers from the Economy Ministry to the Bank of Spain and boosting the central bank’s independence.

The plan has come in for criticism as well as praise even as it makes Ireland and Greece hopeful that they might also be able to win a loosening of the terms of their own bailouts. Christian Schultz, a senior economist at Berenberg Bank in London and a former ECB official, said in the report of the relaxed deadline, “Europeans are learning from past mistakes. The stick is necessary but the carrot is also good.”

However, “Just when you think reason and pragmatism are returning, European policymakers resort to type,” Dario Perkins, an economist at Lombard Street Research in London, commented in a research note. “Significant fiscal tightening was the last thing the economy needed.” New budget cuts added to those already pushed through could cause Spain to fall deeper into recession—like Greece.

As eurozone countries combat the crisis in various ways, the ECB has seen an immediate effect from its action of dropping its benchmark interest rate for overnight deposits to zero. Reuters reported Thursday that the previous day had been the first day for the new policy to take effect, and the response was dramatic. Overnight deposits tumbled by more than half, and one ECB official said that he was hopeful banks would turn to lending instead of simply parking the money.

ECB Governing Council member Josef Bonnici was quoted saying, “Especially the fact that the deposit rate was reduced to zero provides an incentive for the banking system to look what alternatives there are to improve their earnings. This may lead to greater borrowing, especially in some member states."

The move seems destined to open up credit in the sagging eurozone economy and provide a boost to businesses who have been unable to finance operations. While it remains to be seen whether that happens—in fact, ECB President Mario Draghi has said he does not expect it to have a substantial influence on the extra cash of banks or investors—it certainly has affected how much money was left at the ECB overnight.

According to the bank’s figures, Wednesday night deposits totaled 325 billion euros ($396.1 billion). On Tuesday night deposits totaled 800 billion euros, and, in what might be a more accurate indicator of the policy’s effect, at the same point in the monthly reserves period in June deposits were at 700 billion euros.

As each month’s reserves cycle begins, banks have more ways available to move and park funds, so ECB deposits are usually lower before accumulating as the month progresses.

A June meeting of the ECB's money-market contact group, made up of approximately 20 top traders and several ECB experts, had some warnings about the possible effects of cutting the rate to zero. Among the effects they cited were the possibility of a drop in market activity as “as it would remove an incentive to trade”; also, “financial corporations could be expected to shift outside of Europe” and their profitability could suffer.

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