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Prospects Weekly: European Central Bank lending operations provide support to European banks and sovereigns

Global Macroeconomics Team's picture

The European Central Bank provided some half a trillion euros in lending to European banks in a second tranche of its Long-Term Re-financing Operation(LTRO), which has so far proven effective in stabilizing financial markets. Nonetheless the structural challenges in European banking system still remain. The sharp deceleration in global trade has most likely halted, benefiting from the stabilization of the situation in Europe, restoration of previously disrupted supply chains in East Asia (due to Thai floods) and expansion in output elsewhere in the global economy. Inflationary pressures in developing countries have fallen in recent months, however higher oil prices, if sustained, may stoke inflationary pressures once again.

European Central Bank lending operations provide support to European banks and sovereigns. The ECB dispensed a second €530 billion tranche of low-cost three year loans to some 800 European banks (versus 523 banks in the first tranche) this week. This brings total lending under the program to €1,019 billion. The LTRO has eased funding pressures for both banks and troubled Euro Area sovereigns. Banks have used the cheap loans to buy higher yielding sovereign debt in a “carry” trade that has contributed to a decline in government bond yields, increased bank profitability and contributed to a 32 basis point decline in the Euribor-Eonia spread since mid-December – a sign that fears of banking-sector counter-party risk are declining. Despite support from the LTRO, Euro-Area bank-lending remains weak as banks continue to build up capital adequacy ratios and mark-to-market sovereign bond holdings as required by recent regulatory changes.

The deceleration in global trade volumes has most likely bottomed out. Global trade volume growth decelerated sharply in the second half of 2011, in response to falling import demand in Europe and Thai flood-related supply chain disruptions in East Asia. Although global import volumes continued to decline at a 10.8 percent annualized pace during the three month ending December. Recent data suggests that the contraction may be coming to an end. Most of the quarterly decline reflected weakness in October. Global imports were actually rising at a modest 0.5 percent annualized pace in the final two months of the year. Trade growth is expected to continue to strengthen as the situation in Europe stabilizes, supply chains in East Asia are restored, and output continues to expand in both non-European high-income and developing worlds. Indeed, the January JP Morgan Global Manufacturing PMI index shows new orders rising for the first time since August.


Inflationary pressures ease though risks remain. Lower and relatively stable food and fuel prices through much of 2011, policy tightening in some large developing countries, and a slower global economy have led to an easing of inflationary pressures in both high-income and developing countries since H2 2011. Continued soft (albeit strengthening) global growth should keep inflation at bay. However, the recent rise in oil prices due to ongoing geo-political tensions in the Strait of Hormuz, could, if sustained, stoke inflationary pressures once again. 

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