EUROZONE AND QUANTITATIVE EASING: WILL MARIO DRAGHI GET THE SUPPORT? – BY Dr. BOBBY SRINIVASAN AND Dr. SUDHAKAR BALACHANDRAN

December 12, 2014 | Posted by bobbysrinivasan << back to blog

The Eurozone Central bank chief, Mario Draghi, made a commitment a couple of years ago that he would do whatever is necessary to save the euro. Since he dropped the interest rate a few months back, from a meagre 0.15% to 0.05%, the currency market went berserk and pushed the euro from a level of 1.37 to 1.24, a drop of nearly 10% against the dollar. Mr. Draghi , realizing that in the quarter the Eurozone economy grew a meagre 0.2% wanted to start quantitative easing (QE). By the way QE involves the Central Bank buying all sorts of financial instruments right from the government bonds, good quality corporate bonds. The quantum of purchase of these bonds will be announced and hopefully will be transparent. Mr. Draghi talks of returning the ECB balance sheet to its size in early 2012 which implies buying 1 trillion euro worth of bonds.

This, of course, is a shift from the usual, namely, keep pushing the interest rates lower to revive the economy. The Eurozone interest rate is already near zero. But Draghi is facing stiff opposition. Jans Weidmann, the German Bundes Bank President doubts whether this will work. Setting a target to purchase sovereign debt, he believes will not be easy. The questions raised are:

Which country’s bond will he buy?
Will he buy the already existing bond or the newly issued one?
What should be the rating of these bonds?
Can he buy junk bonds?

Mr. Draghi faces this daunting task. He has to push up the inflation to positive territory. He should also achieve growth. Once committed to QE, he should not hesitate as delay in a deflationary environment is quite dangerous. Look at Japan, its economy is in stagnation for nearly 2 decades.

Mr. Draghi can learn some lessons both from Britain and the US. For example, the US adapted QE after the sub-prime crisis of 2008. Before the country was losing around 700,000 jobs every month. Currently, they are creating atleast 200,000 jobs every month. If Draghi had to implement the QE, it is suggested that he should be buying more asset backed securities and corporate bonds. It is these corporations, who are otherwise profitable except the liquidity problem, who should be financed as they are only capable of returning the borrowed money.

In summary, in quantitative easing, the central bank should ensure that all the assets they are purchasing are capable of returning the funds that they had borrowed with interest.

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