Last week, the ECB provided unprecedented three year refinance to banks in Europe against low rated collaterals (A or above) for a record 489 billion Euros at 1%. We can argue whether this operation is just a liquidity support or whether the ECB has now started providing solvency (given the rate, the rating and the period of funding) to its constituent banks, till the cows come home. However, one thing is very clear – the ECB has found an effective template for circumventing the spirit of European Treaties and provide unlimited finance to sovereigns via the banking system. This unlimited guaranteed, low cost funding can prove a strong sedative for the European Sovereign Crisis.
The above operation, coupled with the decision of FED to provide dollar funding at reduced interest rates to European (and other) banks through their respective central banks, means that the market has received a double dose of strong sedatives in last five weeks or so.
This infusion of massive liquidity is more potent than FED’s QE II carried out from Nov 2010 to May 2011. It will, in all likelihood, reduce the severity of deflation which would have otherwise hit the global economy in 2012. And, it may not cause immediate inflation in consumer goods given the negative outlook in Europe and mild outlook in BRIC nations and Japan.
However, the above measures fail to address the problem of current capital shortfall for European Banks. Hence, we still see a possibility of a global deleveraging lead by European banks. However, the effect on asset prices will be muted as compared to what would have happened had the ECB and FED not undertaken these measures.
For India, the combined effect of the above two measures looks like a lifeline from heaven. This has the potential to put a floor on the Indian Rupee and on Indian equity valuations. However, whether this potential can be transformed into reality depends on the intensity with which the government carries out economic reforms and puts its fiscal house in order. Going by the recent actions (and not by the words), we are falling well short on action, and an urgent corrective action is needed right now to get the full benefit of the tidal waves of global liquidity unleashed by ECB and FED.