Has the ECB’s Rate Cut Changed the Economic Climate in Europe?

European Union

European banks are repaying their loans at a rate slower than what was anticipated, Reuters reports. In another consequence of the European Central Bank’s interest rate cut, the region’s banks have decided to be less aggressive in repaying loans that they owe to the central bank. While 4 billion euros of repayment were expected to be repaid later this month, the actual total that banks will pay back will barely exceed 3.5 billion euros.

Last week, the European Central Bank decided to slash its main interest rate from 0.5 percent to 0.25 percent in an effort to bolster inflation rates in the eurozone. When interest rates are lower, it is more attractive for banks to hold on to money than to repay loans as the money is available at a lower cost.

When banks decide not to repay loans, the level of liquidity in the system increases. Currently, the amount of excess liquidity in the eurozone is estimated to be around 170 million euros, down drastically from levels in years past when the ECB initiated two major long-term lending operations. As liquidity drops, capital becomes more scare, which could drive market interest rates higher, which is another fear of the the central bank.

Thus, by cutting interest rates, the central bank has managed to kill several birds with one stone. While many economists expect the bank to conduct an additional lending operation early next year to boost liquidity levels, the move may be able to be delayed now that liquidity will be kept up by the lower interest rates. At least on a temporary basis, lowering the interest rates has given the bank more flexibility when it comes to its other policies.

Another consequence of the bank’s move has been to reduce the value of the euro. The currency has dropped dramatically since the bank’s announcement, erasing a decent portion of the gains that it has made against other international currencies so far this year. When the euro is lower, exporters across the eurozone are helped, as they are able to get more euros for each unit of other currency that the obtain overseas. With many economies in the region becoming increasingly dependent on exporting, the bank has cleverly found a way to reduce the value of the euro as well.

Furthermore, several bank executives have hinted that additional measures may be in store, aside from the creation of another lending operation. Asset purchases, which would be the equivalent of quantitative easing, are provided for in the bank’s mandate. However, since there is no single eurozone bond, it might be difficult to implement on a practical level, meaning that most analysts do not believe that the central bank will attempt such a measure unless economic conditions in the region become particularly dire.

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