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UPDATED: July 18, 2015 NO. 9 FEBRUARY 26, 2015
Stabilizing the Eurozone
Stimulus plus interest rate adjustment provide strategic pivots for EU monetary policy
By Hu Kun

STIMULUS LAUNCH: European Central Bank President Mario Draghi speaks at a press conference in Frankfurt, Germany, on January 22, announcing an expanded asset purchase program in a bid to address the risks of a prolonged low-inflation period (XINHUA)

Responding to heavy pressure by its member states, the European Central Bank (ECB) has issued a stimulus package to shore up the flagging eurozone economy.

The Governing Council of the ECB announced an expanded asset purchase program on January 22, in which the central bank will buy sovereign bonds and private sector assets amounting to 60 billion euro ($68 billion) monthly beginning in March and lasting until at least September 2016. The program aims to fulfill the ECB's price stability mandate and address the risks of a prolonged low-inflation period. Central bank officials expect the program will promote investment and consumption, and ultimately help medium-term inflation rates in the eurozone return to around 2 percent.

The eurozone's GDP accounts for one fifth of the world economy, and a weak eurozone will drag down global economic growth. Mario Draghi, President of the ECB, warned at an EU summit last October that the eurozone faces the risk of falling back into recession unless swift action is taken.

Last November, the European Commission revised the eurozone's growth rate downward, predicting a 1.1 percent and 1.7 percent in 2015 and 2016, respectively. Major EU economies are less optimistic, which in turn affect the overall recovery of the eurozone. For example, Germany's growth may come to a halt; France will continue stagnating; and Italy is on the verge of further economic decline. Even if the bloc avoids falling into an overall decline, another year could pass before even modest growth is achieved.

The need for QE

Along with the stimulus package, the ECB will adjust the interest rate to maintain stable prices—a key task of the central bank. However, adjusting the interest rate alone cannot solve all of its problems.

After a short-term climb in mid-2013, the growth rate of consumer prices in the eurozone began to fall. Last December, the eurozone fell into a technical deflation when the inflation rate went into negative territory—hitting minus 0.2 percent. It appears that a unified monetary policy cannot equip the ECB with the ability to maintain steady prices among its member states.

Generally speaking, the average annual growth rate of medium-term prices should not exceed 2 percent. Amid the prolonged sluggish economy, European investor confidence and consumption weakened, while most indicators of actual and expected inflation in the euro area drifted to historic lows.

To some extent, the current economic problems manifest deep-rooted issues from the time the eurozone was established in 1999. Europe's currency integration was fulfilled, in large part due to the strong political will of EU member states, while inherent economic weaknesses were overlooked. Members of the eurozone have differentiated from one another in terms of macroeconomic conditions, domestic economic structure and level of strength. These states could no longer coordinate their strength via an exchange rate policy after the euro became their common currency. The eurozone has been unable to find an alternative mechanism, such as establishing a unified financial policy, a free-flowing labor market or a flexible wage and price policy. Thus, the eurozone faces huge macroeconomic imbalances.

Before a financial tsunami swept the global economy in 2008, the risk to the eurozone was mainly revealed in serious payment imbalances due to varying levels of strength among member economies. These imbalances grew after 2008, as some EU member states were strong while others were too weak to cope with the impact of the financial crisis. The disparities impacted economic growth, consumption, employment, public finance and financial markets. Ultimately, a vicious cycle emerged, featuring a banking crisis and sovereign debt crisis.

Panic in the financial market led to credit and liquidity contraction. As inflation pressure eased, the ECB implemented many unconventional measures to offer low-interest liquidity in an attempt to improve financial conditions. However, these practices could not dispel market panic, as the eurozone lacks a universally recognized last-resort lender. With nervous banks and a seriously distorted government bond market, the difficulty and cost of financing in the eurozone soared.

Facing harsh reality, the ECB began to look for other monetary policy solutions apart from interest rate adjustments. The central bank introduced the Outright Monetary Transactions (OMT) program on September 6, 2012. The program stated that if an aid recipient met the conditions of the primary market in line with specifications of the European Financial Stability Facility/European Stability Mechanism (EFSF/ESM) program, the ECB would buy its sovereign bonds with a maturity between one and three years in the secondary market on an unlimited basis. This measure sought to stabilize the heavily distorted government bonds market and safeguard the singleness of the monetary policy, as well as to maintain price stability in the eurozone.

Following its implementation, the central bank and EFSF/ESM jointly worked as the lenders of last resort. Confidence in the euro rose significantly in the international financial market. The short-term risk of collapse caused by a liquidity squeeze in the eurozone immediately disappeared.

The ECB has continued to revise down every key interest rate since the end of 2012, but disparities in the eurozone prevent the OMT equal effectiveness among all member states. In advanced economies like Germany, private sector bank loans are sufficient while the inflation rate remains steady. However, in troubled economies, because of a slack market and lack of confidence, a low interest rate does not usher capital into the real economy while private sector loans continue to drop. Instead, money only flows between banks, intensifying the economic downturn and causing a lower inflation rate.

However, drastic fluctuations in the financial market and the huge gap between eurozone member economies make it particularly hard for the ECB to create a unified interest rate policy that suits all members—a task the OMT did not fundamentally resolve, either.

Under these circumstances, the ECB took the decision to carry out a quantitative easing (QE) monetary policy.

Gaining momentum

In March 2015, the ECB will start to coordinate the purchase of investment-grade securities issued by euro area governments and agencies in the secondary market based on member states' shares in the ECB's core capital. Members will have the ability to decide purchases on their own and retain monetary flexibility. This will be conducive for member states' ability to reduce imbalances caused by monetary policies' transmission mechanisms. In addition to interest rates, transmission mechanisms have become another important tool for the ECB in implementing its monetary policy.

Since the QE policy announcement, the European market hoped that the stimulus will promote the eurozone's economic recovery. However, it should be made clear that the current purchasing program focuses solely on maintaining a stable monetary environment. The eurozone still has many other problems to address—such as fiscal flaws and imbalanced economies.

The stimulus package is a necessary measure for economic governance in the eurozone. However, the program could cause a chain reaction of currency depreciation. More euro liquidity will naturally promote a speedy depreciation in the short term.

With more liquidity, "hot money" in the form of euros will likely swarm into emerging economies for speculation, which will lead to price turbulence in stock markets, currencies and bulk commodities. Thus, the world should exercise caution in the face of possible risks of the ECB's QE. 

The author is an assistant researcher with the Institute of European Studies under the Chinese Academy of Social Sciences

Email us at: liuyunyun@bjreview.com

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