Deflation Prospect Concerns European Credit Investors

European credit investors are increasingly wary of deflation, but are sceptical that the quantitative easing (QE) programme announced last month by the European central Bank (ECB) will help, according to Fitch Ratings’ latest senior investor survey.

An all-time high of 65% of respondents rate the risk of deflation as high, up from 53% in the credit ratings agency’s (CRA) previous survey in October 2014. But only 27% think that ECB QE will help address disinflationary trends. Some 92% of respondents thought ECB QE would be positive for capital markets.

Fitch’s base case is that the eurozone will avoid prolonged deflation as its economic recovery gradually accelerates and oil prices rise. The CRA says that it will lower its eurozone inflation forecast for 2015 in the next update of the quarterly Global Economic Outlook in March, as cheaper energy reduces headline consumer prices. However, it still expects eurozone inflation to pick up again in 2016.

Nevertheless, deflation remains a meaningful risk given
the fragile eurozone recovery
and low inflation expectations. Eurostat this week confirmed that euro area annual inflation fell to -0.6% in January, from -0.2% in December. European Union (EU) annual inflation was -0.5% in January, with 23 of the 28 EU member states recording negative annual rates. The lowest annual rate was in Greece (-2.8%).

Fitch comments that protracted deflation would be negative for sovereigns and banks. It could lead to higher real interest rates, rising real debt burdens, weakening of both asset prices (and therefore collateral values) and asset quality, and deferred consumption and investment. Addressing problem loans will be more challenging should deflation take hold.

By reducing the risk of prolonged deflation and recession, QE can mitigate these risks. But it is still unclear what effect the QE programmes undertaken in some major advanced economies since the global financial crisis have had through the various monetary transmission channels.

On 22 January, the ECB announced that it will include sovereign bonds in its asset purchase programme, increasing the size of the potentially open-ended programme to €1 trillion September 2016. Fitch believes that such large-scale QE could have a positive effect on the eurozone economic outlook, principally through higher confidence and a depreciation of the exchange rate. It therefore reduces downside risks versus the counter-factual of no action.

However, any boost from QE via bank lending may be limited given that most banks already have ample funding and liquidity but face a lack of demand for credit, or there is high credit risk on potential loans and fierce competition is making such prospects increasingly less economically feasible. Eurozone banks’ focus continues to be on strengthening their balance sheets to meet ever increasing regulatory demands, a focus that favours continued deleveraging rather than loan growth.

Fitch therefore concludes that ECB QE is unlikely to kick-start lending in the bloc – a view which may be shared by survey respondents. Although a narrow majority (52%) think commercial bank lending conditions in Europe for SMEs will loosen moderately over the next 12 months, only 4% think standards will loosen significantly.

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