Tuesday, 28 October 2014
A Plumber's Guide to the Blockage in ECB Liquidity Transmission.
There has been a lot of talk over the past two week’s about European banks, their balance sheets, ECB corporate bond purchases and the general provision of liquidity to the economy by the ECB and how and if it is actually reaching the intended beneficiaries.
I have followed the liquidity analogy to come up with a water pipework diagram of how I picture this. I know this is far too simplified but here we go -
After the various financial crises (global and European banking), the first destination for central bank liquidity has been to refill the balance sheets of the banks so that once again replete they can start to pump money further down the pipe towards the rest of the economy. The debate still rages as to whether the European banks' balance sheets are in a fully functioning state yet to pass on the liquidity as has been testament by the debate over the European Stress tests, but let's assume they are and the liquidity flows on.
Once released from the balance sheets the liquidity is passed out of the banks on to corporates and to the general populace but not after seeing a proportion syphoned off as bank margins to support more onerous credit and regulatory costs and of course as, hopefully, profit.
One of the concerns has been that banks have been absorbing the added liquidity to such an extent that they have haven't been effectively passing it on and this is why any new ECB program to purchase corporate bonds directly will bypass any restrictions to flow from the banks instead benefiting corporates directly.
So now corporates are getting liquidity injections from two directions. But there is still no benefit to the economy unless they utilise that liquidity in a way that will lead to growth. There is plenty of evidence, though I am too lazy to find and quote any here, that cheap corporate funding has done little to drive corporate investment with cash instead piling up or being used for share buybacks or M+A (which is usually designed to decrease investment rather than increase it). It is at this point that the blockage in the transmission process is occurring.
So here's the catch. If corporates spend on increases in Capex, R+D or other forms real investment, we would see that flow through to jobs, wages and ultimately spending and growth. However in a world of low growth a corporate is hugely unwilling to leverage up if there is no apparent demand. Chicken and egg indeed.
Whilst we hear concerns about unblocking the banks' transmission process (acknowledging the point that the demand side is weak, we are looking at supply side here), I have heard very little about regulatory change that would encourage corporates to spend productively rather than save, other than via monetary policy. Perhaps it is time for the overactive regulators of Europe to turn their beady eyes to those corporates who have been benefitting from cheap liquidity but haven't been passing it on.
Perhaps any ECB corporate bond buying program should be limited to companies that have agreed to some form of spending program as those with the best credit ratings, who will be able to most easily access ECB liquidity, are those in the best shape to pass it on.