March 7, 2012


Title: ECB “Spilled water” helps boost Canadian economy

Sub-title: European Long-Term Refinancing Operations are hard to understand. But their impact is huge.


Economics, which is littered with acronyms such as QE (quantitative easing) and TARP (Targeted Asset Relief Program) recently added another “LTRO” that is increasingly the rage. Like those other initiatives, the European Central Bank “Long-Term Refinancing Operations” are having a major effect throughout the Canadian economy on everything from stock prices to interest rates.


The financing, which was announced in two tranches, one of EUR 489 billion late last year and the second of 529 billion at the end of February, was designed to ease concerns about European sovereign debts and forestall a Lehman-like market seizure, through loans to some 60 financial institutions. The move amounts to indirect financing of member state governments, as many of the beneficiary banks simply use the cheap funds to buy government bonds, which pay a higher rate.


However according to one expert the net effect of LTROs and similar actions by other global central banks will be to pump huge amounts of new money into the global financial system. “Increasing liquidity, as the ECB, the Federal Reserve, the Bank of England and others have done is like spilling water; it won’t just stay in one place. It will flow as far as it can,” says Guy Haselmann, head of US fixed income strategy at Scotiabank. “These operations total close to US $6 trillion. That’s bound to have repercussions beyond those countries immediate borders.”


The backdrop to a significant market rally

“The ECB moves not only helped to shrink credit spreads, but provided the backdrop for a significant equity market rally,” adds Haselmann. “A feedback loop developed, spurred by a wave of easy money elevating asset prices, boosting confidence and leading to a further lurch in asset prices.” The most obvious immediate effects were felt in Europe, where the LTROs and recent Greek bail-out momentum quickly pushed down yields on Italian and Spanish ten–year bonds, to below 5 percentage points, far below previous peaks.


Here in Canada the extra cash in the system eased business and market fears about the European sovereign debts, which had previously stunted new initiatives. Those worries are far from over. However the effect is no longer as paralyzing as it had been.


When interest rates face downward pressure in one market, as they have in Europe, they tend to fell them in other markets too. So while Canadian and US rates have been at rock bottom levels for some time, the ECB’s LTROs have sparked increased confidence that they will stay that way. Finally, a lot of the newly printed LTRO money is also indirectly finding its way into stock prices.


Comes at a good time

Europe’s looser money policy comes at a particularly good time for Canadian exporters, many of which had been concerned that an impending recession on the old continent would cut back on demand. That coupled with a stronger data emerging in the US portends well for the coming months. “Canada’s economy seems to be in better shape than expected,” says Benoit Durocher, a senior economist at Desjardins Economic Studies. “Domestic demand is visibly more vigorous and external trade is increasingly reaping the benefits of the upturn in the United States.”


In fact although Long Term Refinancing Operations are hardly a panacea, says another expert, their effect is clearly positive. “While we are hardly out of the woods yet, risks emanating from the European financial crisis have eased in the last few weeks,” notes Diana Petramala, an economist with TD securities. “As such, business spending should pick up in 2012 along with improving confidence, helping to support Canadian labour markets and overall economic growth.” 


However Haselmann is not as categorical. “Cheap three-year funding has created a disincentive for Eurozone commercial banks to fix their balance sheets and strengthen their capital base,” he notes. “In the short-term, the ECB avoided a credit crunch, but may ultimately have increased systemic risk.”


Whether Haselmann is right or not remains to be seen. However the debate will likely continue to have policymakers, investors and journalists reaching for their economics dictionaries to figure out what “LTRO” stands for.



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