OVERVIEW

ECB’s expected move to cut interest rates to combat eurozone’s deflationary threat would have a positive effect on its economy. The euro will weaken, which is good for its exports but banks and investors would have to find higher yielding investments. This may benefit the emerging markets including Malaysia. However, the adverse effect of possible hot money flows may prompt BNM to be cautious and to remain neutral. Meanwhile, the ringgit is expected to be volatile amid weakening euro and relatively stronger US dollar.

Historic step. As expected ECB has cut its refinancing rates to record lows while imposing negative rates on its overnight depositors, meaning that commercial banks will have to pay to leave money in the central bank, rather than receive interest. Base interest rate is reduced to 0.15% from 0.25% while the deposit rate is lowered to minus 0.1%.

Welcome to NIRP. The move is unprecedented and it’s the first of the “Big Four” central banks (the other three being the US Federal Reserve, the Bank of Japan and the Bank of England) to do this. Though Japan has popularized the zero interest rate policy (ZIRP), ECB could do the same for negative interest rate policy (NIRP). Very few countries have done so, in which Denmark is one of them, but saw little effect as it didn’t really boost lending. For one thing, the minus 0.1% rate is too small to change banking behaviour.

Spur growth and combat deflation. ECB’s president Mario Draghi said the main aim of its policy is to incentivise the banks to lend to businesses, thereby stimulating growth and to stop the eurozone from falling into a deflationary trap. However, the consequences are unpredictable as the market remains unsure how European banks will respond to this very unusual move. The fact that the ECB chose to do this in the face of that uncertainty is a very telling indication of its concerns about the weakness of the eurozone recovery and the dangers of deflation. The eurozone economy grew only 0.2% in the 1Q14 and inflation is hovering around 0.5%, well below the ECB’s target of just under 2.0%. Unemployment is already at nearly 12.0% in the Eurozone and much higher in places like Spain, Portugal and Greece.

Hinting of QE. What has surprised the market is that Draghi is considering Quantitative Easing (QE) – purchases of "asset-backed securities" as he calls it - as part of the measures. Draghi and the 23 other members of the governing council at the European Central Bank indicated that they would take swift action if necessary, including using “combination of measures. This package includes further reductions in the key ECB interest rates, targeted longer-term refinancing operations, preparatory work related to outright purchases of asset-backed securities and a prolongation of the fixed-rate full allotment tender procedures." Concerning ECB’s forward guidance, Draghi said “the key ECB interest rates will remain at present levels for an extended period of time in view of the current outlook for inflation.”

Positive move. Cutting the refinance rate and imposing negative deposit rates are positive steps, but the real game changers are the credit easing measures which will boost liquidity in the eurozone, and reduce borrowing costs in the periphery. A European-style Funding for Lending scheme has long been called for, and its creation should help stimulate job growth. ECB may still need to employ an aggressive program of buying assets, similar to those by central banks in the U.S. and Japan, where consumer prices have been edging higher. On top of that, the eurozone has to strengthen its banking system, and Germany, the eurozone's powerhouse that is running a large surplus, needs to boost domestic demand.

BNM to remain neutral. The ECB move may have a positive effect on the Emerging Markets (EM) whereby investors would scurry to find higher yield investment alternatives. On that note we reckon that the EM central banks would brace themselves for a fresh wave of fund flows coming from the eurozone once ECB decides to announce its own QE, which it has strongly hinted. We expect BNM to be cautious as the financial market is still reeling from the effect of the QE tapering by the US Federal Reserve. We maintain our view that BNM would maintain the OPR at 3.00% for this year and the next. Meanwhile, we expect the ringgit to remain volatile amid weakening euro and the stronger US dollar. We maintain our year-end target for USDMYR at 3.21.

Source: Kenanga