Speculation about a possible European version of quantitative easing has reached fever pitch ahead of Thursday's meeting of the European Central Bank's monetary policy committee. Declining inflation and continued sluggishness in credit markets call for action. Meanwhile, Mario Draghi's recent speech at the Jackson Hole central-banking retreat suggest the ECB chairman is newly open to more aggressive easing. But Europe's problems are different and more complex than those of the U.S., and investors hoping for a Fed-style QE "bazooka" could end up being disappointed.
The ECB faces two policy challenges. First, inflation expectations are falling in a pattern dangerously replicating Japan's lost decade. The market expectation for inflation in five years fell below 2% last week, while the expected rate a year from now is below 1%. Both these figures fall short of the ECB's 2% target, and history suggests that once deflation expectations take root, getting back to a positive course becomes extremely difficult.
The second problem is the transmission of credit to European firms. Despite low ECB rates, companies in the peripheral economies still must pay 1.5 to two times as much as their German peers to borrow. For a company whose debt is five times annual earnings, borrowing at 5% instead of 3% means 10% less profits.
To bring inflation expectations back to normal, the ECB could push the euro lower relative to other major currencies by buying sovereign bonds and expanding its balance sheet. The euro's appreciation since its trough in 2012 has pushed inflation down by half a percentage point over that time, according to the ECB. But there are some counter-indications to sovereign-bond purchases. First, Mr. Draghi has already managed to bring down the euro merely with a promise to act. Second, buying sovereign debt at current yields—2.4% for Italy and 1.3% for France's 10-year bonds—could prove harder to justify against the lack of underlying regulatory reforms.
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Eventually, the ECB may still be forced to implement asset purchases if inflation expectations continue to drop. But as we have seen before, lower sovereign yields may do little for Europe's real economy, where small firms create 85% of new jobs but can't borrow in bond markets. "Monetary policy can only buy time," German Finance Minister Wolfgang Schäuble said last week. He's right.
The real game-changer for growth instead is to reform the mechanism of credit transmission to European firms from banks to capital markets. European firms rely on banks for 80% of their credit because most are too small to issue bonds on their own. Europe needs to shift from a sovereign-guaranteed, bank-centered credit system to a more balanced mix of fewer banks and more bonds.
Asset-backed securities, or ABS, are one instrument that can help, if they become more common. These bonds, backed by bundles of corporate and consumer loans, can create a new channel for credit to reach small firms. Regulators need to find ways to encourage this market to develop faster.
This type of debt security gained a bad reputation after the subprime mortgage crisis, in which securities backed by defaulting mortgages badly dented the balance sheets of the banks that held these assets. Yet this was chiefly an American problem. Only 1.5% of European asset-backed securities suffered losses between 2007-13, compared to up to 18% in the U.S. Regulators, including the Basel Committee of central bankers, reacted by tightening capital requirements, yet without taking into account the lower risk in the European market.
The ECB, which last week announced it has hired BlackRock Solutions as its adviser for a potential ABS purchase program, can play a significant role in improving things. For one, the central bank can set the tone for what kinds of ABS are considered suitable for banks to hold and which aren't. Mr. Draghi has said that in any program, the ECB would buy only securities that are "simple, transparent and real." By eschewing the sort of opaque securities that wreaked so much havoc in the U.S., Mr. Draghi can send a useful signal.
At the same time, the ECB's willingness to buy such securities would shake up what is currently a relatively small market. Asset-backed securities worth only about €300 billion ($393 billion) are currently outstanding in Europe, according to the Securities Industry and Financial Markets Association, and more than half of those are sitting untraded on bank balance sheets. The ECB can encourage more issuance, and thus more underlying lending, simply by being willing to buy.
Other regulators also will have a role to play. The Basel Committee should consider whether the relatively good track record of asset-backed securities in Europe warrants the risky weighting they receive in current bank-capital standards. Local regulators also will play a role in promoting the development of suitable securities in each jurisdiction, and knocking down barriers to new lenders, such as lack of public loan-level information.
All of these factors make it unlikely that an ABS-purchase program will get off to a running start if and when Mr. Draghi unveils one. As a result, investors hoping for imminent big news about massive asset purchases by the ECB are likely to be disappointed, both this week and in the next few meetings. But they shouldn't lose sight of other options. Purchasing sovereign debt isn't the only available response. Developing a well-functioning market for asset-backed securities could finally be a structural solution to Europe's credit drought.
Mr. Gallo is the head of macro-credit research at the Royal Bank of Scotland. The views expressed are his own.