Improvements in the euro area credit conditions should not be ignored

While there is almost no coverage of this topic in the financial media and the blogosphere, credit conditions in the Eurozone are showing marked improvements. This is an unpopular view these days, but ignoring the trend results in an incomplete view of the area's economy and markets. Here are the key indicators:

1. Credit supply/demand fundamentals are trending in the positive direction. Loan demand has improved dramatically and credit standards are looser than at any time since the Great Recession.

This shows indicators for corporate loans and residential mortgages (source: ECB)

2. Since the conclusion of ECB's stress tests in early 2014 (which had been a major source of uncertainty for banks in 2013), loan balances in the Eurozone are beginning to stabilize. Corporate loans are still declining (as maturing loans are not being fully replaced by new loans) but at a much slower rate. These improvements are of course dwarfed by credit expansion in the US where loan balances are growing at over 8% per year (see chart). Nevertheless, the painful deleveraging process in the euro area's banking system is coming to an end.

Source: ECB (adjusted for sales and securitization)

3. Lending rates in the Eurozone periphery are declining sharply. The so-called "monetary transmission" of zero ECB policy rate into rates paid by borrowers is still not great, but the process is starting to work.

Source: @sobata416 

4. Corporate capital markets flows in the EU have jumped recently and a number of Eurozone-based companies will benefit from this trend. Cash-rich euro area investors are shopping for yield and now there is some demand from the corporate sector.

Source:  @lcdnews 

5. Perhaps the best indicator of credit expansion and diminishing effects of bank deleveraging is the growth in the Eurozone's broad money supply. The improvements which followed the ECB's stress tests have been impressive.

Source: Investing.com

Why then do we need such an aggressive monetary response from the ECB? The answer has to do with rising deflationary risks in the euro area. While some have associated falling inflation with sharp declines in energy prices, the issue in the Eurozone is broader than energy (see "core" CPI). And deflation could easily extinguish this nascent improvement in credit.

Clearly the area faces significant headwinds such as the mess related to Greece. Rising probability of "Grexit" for example could dampen lending in other nations. The improvements to date however have been impressive and should not be ignored.

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Rotation out of money market funds - where is the cash going?

Investors are fleeing dollar-based money market funds. After the spike in cash holdings from taxable income "harvesting" at the end of 2012 (see discussion), the assets in money funds have declined sharply.

Source: ICI

What's causing this decline? The common explanation has been a major rotation into equities. That certainly explains some of it, but there is more to the story. Some institutional investors are becoming uneasy about the impending money market funds regulation. Not only are investors paid a near zero rate on their money market holdings, they also may be subject to some NAV fluctuations in the near future. Furthermore, the NAV fluctuations may only be applied to funds holding commercial paper and not to those holding just treasury bills or treasury repo.

Reuters: - Two-tier money market fund reform is as clear as mud. The U.S. Securities and Exchange Commission is trying again to regulate these mutual funds, which compete with bank deposit accounts. But the rules could favor funds that invest in government debt over those buying corporate debt.

The SEC isn't talking specifics, but Larry Fink, chief executive officer of BlackRock, is. He told analysts this week that some funds may have to adopt a floating net asset value (NAV) - a standard in the mutual fund industry but anathema to those running these accounts that invest in short-term debt. That's because investors, who view money market funds as higher-yielding savings accounts, could actually lose money if NAV is no longer pegged to $1 per share. But the scheme is the best option floated by regulators who want to stop 2008-like runs from happening again. It's simple and puts risk back where it belongs: on investors.

But, according to Fink, it seems a floating NAV may not be applied to funds that invest in government debt like U.S. Treasuries. In a letter to regulators last December, BlackRock argued these funds, which represent 45 percent of the $2.5 trillion market, should be exempt. After all, they weren't part of the panic in 2008, which forced the government to bail out the industry with a blanket guarantee.
...
It's not clear why there need to be two sets of rules for money market funds, other than the need to get a deal done. The effort to reform money market funds has been a long slog. And the SEC has already failed once to overhaul the industry. Compromise may be necessary, but it shouldn't come at the expense of sensible regulation.

The whole attraction of money market funds has been the stability of principal. But with this type of regulatory risk, investors may be better off moving cash into short-term bond funds or ETFs. If one is going to be subject to volatility, why not hold money in something like the PIMCO Enhanced Short Maturity Strategy ETF (MINT), yielding 75bp. That's in contrast to PIMCO's Institutional Money Market Fund (PMIXX) which pays precisely zero, while its NAV may drop below par.

Not surprisingly, that's precisely what investors have been doing. In March short-term bond mutual funds and ETFs have clocked the largest inflow since 2009.

Source: JPMorgan

One unintended consequence of this shift to bond funds will be perturbations in some measures of money supply. Money market funds traditionally have been included in certain broad measures of money stock (such as MZM) while bond funds have not. The definition of "cash equivalents" have now been blurred further. Just watch certain high-profile economists in the next few months mistakenly interpreting this "rotation" as a slowdown in the growth of US money supply.

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Weakness the Eurozone credit growth persists; stark contrast with the US

Tight credit conditions continue to persist in the Eurozone, inhibiting growth and dampening plans for fiscal consolidation.

AP via Yahoo: - Another drop in lending to companies in the 17-country eurozone showed the economic downturn is deepening, as a brighter mood on financial markets fails to catch on with businesses.

The European Central Bank said Thursday that loans to non-bank businesses shrank 1.4 percent year on year in September, double the 0.7 percent contraction reported the month before.

In fact loan growth to households trajectory shows an ongoing decline, while ...

Eurozone banks: loans to households  (YoY; source: ECB)

... loan growth to companies is declining sharply as well.

Eurozone banks: loans to non-financial corporations (YoY; source: ECB)

The stagnation in lending is in part due to banks deleveraging in order to improve capital ratios for Basel III. But a big part of the issue is simply lack of demand from borrowers.

AP via Yahoo: - The numbers show the economy is struggling despite efforts by the central bank to stimulate credit and calm financial markets fearful that the eurozone might break up. The ECB has cut its main interest rate to a record low 0.75 percent and made €1 trillion ($1.3 trillion) in cheap loans to banks that don't have to be paid back for three years.

Even so, that easy money is not making it from banks to businesses and consumers, largely because demand for credit remains weak. Businesses see no reason to borrow to invest in expanding production. Meanwhile, banks in some countries have less to lend because they are struggling to recover from losses on real estate loans that didn't get paid back and on government bonds that have fallen in value due to fears about those governments' finances.

Liquidity is trapped in the Eurozone core where businesses are borrowing less, while periphery banks have limited liquidity even if there was demand. Either way, liquidity provided by the ECB is not making it into the private sector, as the growth in money supply diverges materially from growth in lending to the private sector.

Source: GS

Note that this weakness in credit growth in the Eurozone is in stark contrast with the US, where banks continue to lend at a steady pace. This trend started in early 2011 (driven mostly by corporate lending) and seems to be ongoing.

Loans and leases on balance sheets of US-chartered banks (source FRB; click to expand)

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The rise in the Eurozone money supply has not improved credit conditions

With the second round of the LTRO program, the ECB has managed to slightly improve liquidity in the Eurozone. This is evidenced by the growth in M3, the broad money stock. But as discussed before, this liquidity is not translating into area-wide improvements in the overall credit conditions. In fact the trend in lending to the private sector has completely diverged from M3.

Eurozone M3 vs loans to the private sector (source: GS)

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The ECB has completely lost control over the monetary policy for Greece

The Bank of Greece balance sheet has expanded sharply this year. This of course is part of the ECB's balance sheet expansion on a consolidated basis. But the Greek central bank's balance sheet by itself is now almost €200 billion. That's an unprecedented amount for Greece and represents over 65% of the nation's annual GDP. It is also close to a 50% increase year-over-year.

Bank of Greece balance sheet ( €mm, source: BoG)

One would expect at least some impact on the monetary aggregates from such a dramatic expansion. Yet the money supply measures, both narrow and broad have collapsed. We've seen this before with other periphery nations such as Italy. But nothing on this magnitude.

Greece contribution to Eurozone's money stock year-over-year growth (source: BOG)

This trend shows a massive drain of liquidity out of the system that will result in a total seizure of credit. How can the ECB claim any control over the monetary policy when a 50% increase in the Greek central bank's balance sheet results in a 16% decline in M1 and nearly a 20% decline in M3 money stock?  Greece is now in a  permanent state of extraordinarily tight monetary conditions no matter what the central bank does. In such an environment there is absolutely no hope for any growth, let alone fiscal consolidation. It seems the only possible solution for Greece may be to take control of its own monetary policy, which would require abandoning the euro. An ugly outcome, but given the ECB's inability to stabilize Greece's rapidly shrinking money supply, there may be little choice.

Update: see some insightful comments below from Kostas Kalevras on the topic.

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Contraction in Eurozone's repo markets is driving M3 decline

Yesterday the ECB released its monetary aggregates measures for the Eurozone through Dec-2011. The following chart shows the absolute level of Eurozone's M3 aggregate, a broad measure of money stock. (Note that at times it is helpful to look at monetary indicators on an absolute basis rather than as percent changes as economists tend to do.)  The upward trend in the money supply growth has reversed, mostly during the last quarter of 2011.

Eurozone M3 in EUR billion (seasonally adjusted)

An obvious question here is whether this broad money supply decline is similar to the US during 2008-2010. One key component of M3 driving this contraction in money stock is the amount of repo (secured) lending. The Eurozone repo loan balances have declined materially in Q4 - an issue that is quite different from what had occurred in the US.

Repurchase agreements (repo) component of  Eurozone's M3 in EUR billion (seasonally adjusted)   

Since repo has become the only form of interbank lending in the Eurozone, this is clearly an indication of deteriorating credit conditions. With the ECB providing longer term financing not available in the interbank repo markets, it is often quite attractive or even necessary for many financial institutions to shift their collateral into an ECB facility (ECB secured loans are not included in the monetary aggregates). LTRO term lending for example provides far more funding stability than rolling short-term interbank repo loans. The ECB has also been considerably more lenient with collateral than the current repo markets. The rapid rise in the ECB's balance sheet (EUR 2.7 trillion) "soaked up" a great deal of the collateral out of the repo markets, dampening growth in interbank credit.

ECB consolidated balance sheet (EUR million)

The pie chart below shows the contribution by country to the drop in the Eurozone repo levels over Q4-2011. Nearly half is coming from Italy as Italian institutions shifted financing to the ECB. It is not surprising therefore that Italy continues to deal with tightening credit conditions that are more extreme than the Eurozone as a whole.

Contribution by country to the Q4 drop in repo component of M3

The unprecedented accommodation provided by the ECB is not yet helping to expand the broad money supply. The banking system has shifted a substantial portion of its eligible collateral from the repo markets to the ECB who is providing longer term stable funding. Only once the dependence on the ECB is reduced and the interbank funding markets begin to heal, will we see a stabilization in M3 growth.

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Eurozone M3 contraction

Below is the latest data from Credit Suisse on the eurozone money stock - M3, the broadest indicator. This is troubling because if Germany's M3 continued to expand, the periphery economies credit conditions deteriorated even faster than the euro area as a whole.

Credit Suisse: That weakness on the money side was reflected in a deterioration in the credit counterparts. Bank lending fell 0.1% on the month. That was largely driven by a drop in loans to firms. Banks also continued to delever outside the euro area. Their net external assets fell EUR25bn in November after a EUR60bn drop in October.

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The ECB's easy monetary policy is not getting to the "periphery"

The monetary contraction in Italy has been continuing, with money supply indicators all showing negative growth.  Here are the latest monetary aggregate contributions to the eurozone from Italy's central bank:

 Banca D'Italia: Italy's contribution to the eurozone money supply (percent YOY)

But shouldn't the ECB's continuing expansion of the balance sheet have some positive impact on Italy's liquidity?  Below are the money supply measures showing year over year growth for the eurozone as a whole.

ECB: total eurozone monetary aggregates growth YOY

The growth is moderately positive at around 2% year over year.  This means the liquidity in the eurozone as a whole is expanding, while Italy's is contracting.  But the eurozone is a "closed system" - if the monetary conditions are contracting in one nation, they must be expanding elsewhere to keep the whole euro area liquidity growing at the 2% level.

As expected, that monetary expansion is in fact taking place in Germany with M2 and M3 growth rates in the 6-7% range.

Bundesbank: Germany's contribution to the eurozone monetary aggregates (percent YOY)

What this shows is that liquidity is not getting to the ECB's target, the "periphery", whose economies are facing a recession.  Instead the monetary expansion is ending up at the "core", making the ECB's policy of easing far less effective. This disparity is also setting up a potential future conflict between Bundesbank and the ECB as the impact of monetary policy is not felt uniformly across the eurozone.

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