Macro Highlights: liquidity will rise further in the Euro zone and is declining in India

Macro Highlights - 14/12/2016

The ECB has decided to extend its asset purchase programme beyond the March 2017 deadline and plans to buy EUR 60 billion worth of securities per month through December 2017. This latest move to expand quantitative easing means the ECB will continue to hold down Euro zone yields. Demonetisation in India is expected to hurt short-term growth. Structural trends and the reform agenda remain on track, however, shoring up the long-term outlook. Analysis by Sophie Casanova.

The 8 December meeting of the European Central Bank (ECB) was probably one of the most highly anticipated events as the end of the year approached. Following this meeting, the ECB announced its monetary policy plans for 2017. It did not modify its interest-rate policy, effectively keeping its deposit rate at -0.40% and its refinancing rate at 0.00%. But it did decide to extend its asset purchase programme beyond the March 2017 deadline that it had previously set for itself, and it tweaked the parameters governing its purchases.

 

Here are the details :

  • The ECB announced that it would continue to buy EUR 80 billion worth of securities per month until March 2017, after which it would reduce its monthly purchases to EUR 60 billion until December 2017 at the earliest.
  • Securities with a maturity of at least one year will now be eligible for purchase (the previous minimum was two years), and the ECB announced that it reserved the right to buy securities with a yield to maturity below -0.40% (which it had ruled out previously).

 

Analysis and implications :

  • The ECB’s decision to prolong its quantitative easing programme was driven by the low inflation outlook in the Euro zone. The ECB's economic staff now forecast 1.7% inflation in 2019, which is still below the ECB’s medium-term target of 2.0%.
  • The pace of the ECB’s purchases will ease starting in April, but the total amount bought in 2017 will surpass the expectations of investors, who had generally assumed that the EUR 80 billion per month amount would remain in effect until September. By extending the programme through December – and despite reducing the monthly amount – the ECB will end up purchasing a total of EUR 540 billion in securities versus the expected amount of EUR 480 billion.
  • The ECB also noted that it could expand the size of the asset purchase programme or extend the deadline even further if necessary. This was tantamount to confirming that, despite slowing the pace of its purchases starting in Q2 2017, the ECB had not set in motion a QE tapering strategy.
  • After the ECB modified some of its parameters, the shortage of eligible securities is no longer a problem. It can now, for example, buy German bonds with a yield to maturity below -0.40%. This move should give the ECB the leeway it needs to carry on with the purchase programme throughout 2017 without a major hitch.

 

These steps mean that the ECB will be in a position to loosen the monetary environment even further in 2017. This should limit upward pressure on long-term sovereign yields in the Euro zone. And even though the ECB did not change its country quotas, its recent statements about departing from them temporarily if necessary (see the Macro Highlights of 5 December) should prevent peripheral yields from rising sharply. By maintaining its forward guidance, according to which the ECB will keep rates low for a long time after it stops buying securities, the ECB will help hold short-term rates down. This could also lead to a slight steepening of the yield curve. The euro should not gain any more ground on the dollar now that the Fed appears set to resume the fed funds rate hike cycle at its meeting on 14 December 2016.

In India, the demonetisation of INR 500 and INR 1,000 banknotes, which began in mid-November, is beginning to have an impact on domestic economic activity. These notes account for around 86% of total cash in the country, or USD 210 billion. Their removal from circulation will put a real crimp on daily economic activity in a largely cash economy – cash is used in 95% of transactions. The composite purchasing managers index dropped from 55.4 to 49.1 in November, pointing to a contraction in economic activity (see left-hand chart). The downturn is more pronounced in the services sector, going from 54.4 to 46.7. In that sector, these banknotes play an outsized role in companies’ working capital, as they are used to pay ongoing expenses like employee wages, and their removal has been particularly painful. Consumer spending has also suffered, with car sales down 11% in November.

After an end-November respite, the liquidity shortfall was keenly felt again in early December, as nearly 45% of cash machines ran out of money. This liquidity squeeze is likely to push down consumer spending. We expect GDP growth to slow over the next two quarters, to 6.9% and 7.0%, respectively, from 7.3% in Q3. Yet we are still bullish on the country’s long-term outlook: we forecast 7.4% GDP growth in 2017 and 7.7% in 2018. Before the demonetisation process ends on 30 December, the government is expected to expand its support measures for the rural population, which has been hardest hit by this policy. This will be fundamental to keeping the situation under control and preventing unrest – a development that would significantly affect our growth forecasts. And although the Reserve Bank of India has held its benchmark rate at 6.25%, it can be expected to lower it in 2017 to boost economic activity. This factor, combined with a prevailing sense of uncertainty, should weigh on the rupee.

The short-term costs are thus likely to be high. But in the longer term, this effort to rein in the parallel economy – which is thought to equal 45% of India’s GDP and 80% of jobs (these estimates vary) – is in line with Prime Minister Modi's reform agenda. The gradual shift of part of the informal economy to the formal sector should serve to expand India's tax base. The country’s tax revenues are low at 10.8% of GDP, which is far behind the 14.7% average among OECD member countries. Demonetisation is also a way of channelling informal savings, which are often invested in gold or real estate, into the banking sector. These added savings could, through the lending process, drive productive investment. This emphasis on bank intermediation together with higher tax revenues could combine to shore up the country’s financial basis and help make up for shortfalls in infrastructure spending. Weak infrastructure trims several points off the country’s GDP growth every year. Out of the INR 14,400 billion affected by demonetisation, the equivalent of INR 11,550 billion has already been reinjected into the system as savings – more than the central bank expected.


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