Cheap funding for European banks from ECB may see some of the liquidity flowing to emerging markets
Earlier this week, the European Central Bank (ECB) announced that 800 banks had borrowed 530 billion euro under its second tranche of long-term refinancing option (LTRO). The ECB opened its long-term refinance window for the first time in December 2011, when European banks were severely cash-strapped and they did not have the required funds to repay maturing debts. As the risk of peripheral European countries defaulting zoomed, some action was required to prevent a banking crisis in the euro zone. The ECB loosened its purse strings through the LTRO, which enabled banks to raise funds for three years at one per cent.
So, why is LTRO important for emerging markets like India? For starters, European banks are flush with funds and after an infusion of one trillion euro, they will not need capital till 2014. This means these banks will not sell assets (especially Asian assets) under stress. But more importantly, some of the liquidity released by the ECB, has found its way into emerging markets like India, pushing up asset prices.
Barclays Capital expects the medium-term effect of
LTRO-2 on emerging market (EM) asset prices to be positive. “However, the risk of profit-taking in the near-term cannot be fully discarded. Our analysis suggests that the historical initial reaction of EM asset prices to non-conventional monetary measures has been fairly muted (with some profit-taking bias), but that in the following months the additional liquidity in the system finds its way to support EM asset prices.” This probably explains why the market did not fall through the week even on weak GDP and PMI numbers.
According to Kotak Institutional Equities, although Indian valuations are fair at 13.8 times earnings per share (12-month forward consensus), these liquidity-injection phases have stretched fair valuations in the past. The brokerage believes this second round of liquidity injection has exceeded its predecessor and may sustain Indian market sentiments in the near term. However, Kotak believes the signals sent by the government through the FY13 Union Budget will be critical in maintaining the positive momentum locally.
If risk appetite continues to improve, the rupee, too, could hold on to its gains. After being beaten down last year, the rupee has outperformed its regional peers year-to-date. If risk appetite continues to improve, the rupee could appreciate further. However, Barclays Capital says, weak fundamentals are likely to limit the rupee appreciation.
The first round of LTRO generally improved not only the health of European banks but also the general risk appetite. However, analysts are not very gung-ho about the second round of easing by ECB. The market is comparing both the LTROs with the two rounds of quantitative easing undertaken by the US Fed. While the first QE worked rather well, the second one did not.
Explains Edelweiss Securities: “Undoubtedly, LTRO–1 has been a phenomenal success, particularly with regard to the banking sector outlook and general risk appetite in financial markets. In fact, it is by far the most aggressive and effective step taken by EU since the onset of the debt crisis. However, it is not yet clear whether LTRO has made any material improvement in the real economy.”
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