Free Exchange

Has the ECB found a way around the lower bound on interest rates?

Its cheap loans to banks could help kickstart inflation




Imagine being locked in a dark room. Fearful of slamming into a wall or tripping, you inch forwards, arms outstretched. That is roughly how the European Central Bank (ECB) has approached interest-rate cuts since it first ventured into sub-zero territory in 2014.

It knows there is a limit to how low rates can go, and that the limit is near, but, like the economics profession more broadly, it has no idea when it will hit the wall. With growth and inflation subdued, it cut rates gingerly, by 0.1 percentage points at a time.

Even before covid-19 struck, its deposit rate was down to -0.5%. Rather than cut rates further, it has since relied on unconventional measures, such as bond-buying. Much of its stimulus has come from expanding its loans to banks, and decoupling the scheme’s interest rate from the main policy rates. With the introduction of dual interest rates, the ecb could well escape its locked room.

Cuts to interest rates are aimed at encouraging firms and households to spend by making borrowing more attractive, and saving less so. But when rates are negative their transmission to the real economy breaks down.

Depositors can always choose to hold their funds in cash, which has an effective interest rate of zero. Banks worry that if they pass on negative rates, customers will yank their money out and stash it under mattresses instead.

The result is squeezed net interest incomes for banks, a hit to their profitability, and, potentially, a reduced willingness to lend. Economists reckon that at a certain point—the so-called reversal rate—the stimulative effect of an interest-rate cut will be offset by the strain placed on banks. Fear of reaching this point helps explain why no central bank has gone deep into negative terrain.

In order to get around the problem, the ECB has souped up its long-term repo operations (LTROS), which lend to banks. When introduced during the euro area’s sovereign-debt crisis in 2011, they were meant to quell fears about banks’ funding shortfalls.

Since then they have come in several flavours, from VLTROS—“very long-term”—to three rounds of TLTROS, or “targeted” operations, to PELTROS, for the “pandemic emergency”, announced in April.

And the intention behind them has changed. tltros are a way to encourage banks to lend to the private sector. The more a bank lends to households and businesses, the lower the rate at which it can Access TLTRO funds, according to a sliding scale set by the ECB. And in the topsy-turvy world of negative rates, the ECB is paying banks to extend credit to the economy.

This sort of scheme is hardly unique. The Bank of England has something similar. But one feature makes the ECB’s set-up novel. Until March the tltro rate was tied to the ECB’s benchmark interest rates. But the link has since been severed, and banks that meet the lending criterion can access funds at a much lower interest rate of -1%.

The result is that banks can now get super-cheap funding, making a profitable spread when they use the proceeds to make new loans. Meanwhile deposit rates remain closer to zero, preventing savers from running to the door.

So far it seems that tltros have been popular and effective. Whereas the Fed this year has mostly focused on supporting capital markets, lending to banks has made up the bulk of the ECB’s stimulus—hardly surprising given the much bigger role banks play in intermediating credit in the euro area.

By August 7th the ECB had lent €1.6trn ($1.9trn or 13% of euro-area GDP) through its lending schemes. In June alone banks borrowed €1.3trn.

Once you add these in, finds Frederik Ducrozet of Pictet Wealth Management, the ECB’s balance-sheet has expanded more quickly this year than the Fed’s (see chart).

In a speech in June Philip Lane, the ECB’s chief economist, reckoned that the measures alone, by averting a liquidity crisis, may prevent output in the euro zone from falling by three percentage points over 2020-22.




Proponents say dual rates could be more powerful still. There is no technical floor on the TLTRO rate: it can fall to -5%, -10%, or further. Lower rates could give inflation, long subdued, the kick it needs.

Meanwhile the central bank could start to raise its deposit rate, satisfying critics in Germany and elsewhere, who worry about the impact of negative rates on savers.

The sliding scale for assessing who gets access to cheaper ECB funding could be altered to, say, improve the transmission of negative rates. Banks could be asked to reprice their existing loan books, suggests Eric Lonergan of M&G Investments, a fund manager; in its most daring form, perpetual TLTROS could require banks to lend at negative rates—a way of transferring cash to citizens.

The art of the posible

Could dual rates in some form become an established part of the toolkit, at the ECB and at other central banks? The impediments may well be political not technical. If a central bank lends to banks at a cheaper rate than the rate at which it remunerates reserves, then it makes a loss. (At the ECB, these losses are probably more than offset by profits on asset purchases.)

Most economists would point out that losses do not matter; central banks can just print more money to pay their bills. But in practice central bankers have been wary of making losses, fearing that recapitalisation by governments might open them up to political pressure and scrutiny.

They may also not want to be seen to be subsidising greedy bankers with deeply negative loan rates: some commentators in France, says Mr Ducrozet, are already muttering that the ECB is doing so. Perhaps it was for a combination of such reasons that Andrew Bailey, the governor of the Bank of England, told Bloomberg on August 6th that he did not expect to follow the ECB’s lead.

Dual rates may also not seem worth bothering with when fiscal policy is the more potent tonic for an economy in a recession. Even the European Union has managed to loosen the fiscal purse strings this time. But a quick, sufficiently large and well-targeted response from governments in the next downturn is not guaranteed.

One lesson from the past decade of attempts to revive growth and inflation is that every stimulus measure has a political downside of one kind or another. If dual interest rates hasten the day that the economy recovers enough for monetary policy to be tightened, then surely they are worth having.

To the Brink with China

The chances of a Sino-American cold war are far higher today than they were just months ago. Even worse, the chances of an actual war, resulting from an incident involving the countries’ militaries, are also greater.

Richard Haass

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NEW YORK – Observers of US-China relations increasingly talk of a new cold war. On top of a long-running trade war, the two countries now find themselves in a destructive cycle of mutual sanctions, consulate closings, and increasingly bellicose official speeches. Efforts to decouple the US economy from China’s are underway as tensions mount in both the South China Sea and the Taiwan Strait.

A cold war between the United States and China would leave both countries and the world worse off. It would be dangerous and costly – not least because it would preclude needed cooperation on a host of regional and global issues.


The good news is that such an outcome is not inevitable. The bad news is the chances of a second cold war are far higher today than they were just months ago. Even worse, the chances of an actual war, resulting from an incident involving the countries’ militaries, are also greater.

Why is this happening?

Some say Sino-American confrontation is inevitable, the result of friction between the established and rising powers of the day. But this overlooks the various episodes in history when such power shifts did not result in war. Even more, it underestimates the importance of decisions already made and yet to be made. For better and for worse, little in history is inevitable.

A more serious assessment of how we got here begins with China.

In recent years, and increasingly in recent months, the Chinese government has embraced a more assertive path at home and abroad. This is reflected in China’s crackdown in Hong Kong in the wake of its enactment of a harsh new national security law; the inhumane treatment of its Muslim Uighur minority; the clashes along its unsettled border with India; the sinking of a Vietnamese vessel in the disputed South China Sea; and regular displays of military strength near both Taiwan and the Senkaku Islands, which both China and Japan claim as their own.

This has triggered deep disillusion with China in the US, compounding underlying tensions stemming from China’s consistent theft of American intellectual property, trade practices that many blame for the disappearance of US manufacturing jobs, a concerted military buildup, and mounting repression at home. Hopes that integration into the global economy would bring about a more open, rules-abiding China have not materialized.

Why is China becoming increasingly assertive now? It could be that President Xi Jinping sees an opportunity to advance Chinese interests while the US is preoccupied with the fallout of COVID-19. Or it could be an outgrowth of China’s desire to distract domestic attention from its initial mishandling of the virus and the economic slowdown exacerbated by the pandemic.

This would not be the first time a government turned to nationalism to change the political conversation.


A third explanation is the most worrisome. In this interpretation, China’s recent behavior is not so much opportunistic or cynical as representative of a new era of Chinese foreign policy, one that reflects the country’s growing strength and ambitions. If this is the case, it reinforces the view that a cold war or worse could materialize.

Of course, all this is taking place during a US election campaign, and President Donald Trump’s administration is seeking to blame others for its own inept handling of the pandemic.

To be sure, China bears more than a little responsibility, as it initially suppressed information about the outbreak, was slow in responding, and failed to cooperate as much as it should have with the World Health Organization and others. But China cannot be blamed for the lack of adequate testing and contact tracing in the US, much less for Trump’s failure to accept science and support social-distancing and mask-wearing mandates.

But it would be wrong to attribute changing US views of China primarily to American domestic politics. A tougher China policy will last regardless of who wins the upcoming presidential election. Indeed, US policy toward China could become even more critical under a President Joe Biden, whose administration would be less preoccupied with negotiating narrow trade agreements and more focused on addressing other troublesome aspects of Chinese behavior.

In the short run, both sides should ensure that crisis communications are in good order, so that they can respond quickly to a military incident and keep it limited. More positively, the two governments could find common ground by making any COVID-19 vaccine available to others, helping poorer countries manage the economic fallout of the pandemic, or both.

After the US election, the two governments should start a quiet strategic dialogue to develop rules of the road for the bilateral relationship. The US will need to abandon unrealistic hopes that it can foster regime change in China and instead focus on shaping China’s external behavior.

China will have to accept that there are limits to what the US and its allies will tolerate when it comes to unilateral acts that seek to alter the status quo in the South China Sea, Taiwan, or with the Senkaku Islands.

In the long run, the best hope is a US-China relationship of managed competition, which would avoid conflict and allow for limited cooperation when it is in both countries’ interest. This may not seem like much, but it is quite ambitious given where things are and where they are heading.


Richard Haass is President of the Council on Foreign Relations and author, most recently, of The World: A Brief Introduction (Penguin Random House, 2020).

Israel and the UAE Formalize Their Normalized Relations

For Abu Dhabi, it’s all about its own security.

By: Hilal Khashan


On Aug. 13, U.S. President Donald Trump announced a historic peace treaty between Israel and the United Arab Emirates, two countries that do not share borders and have never gone to war against each other.

The agreement formalizes relations that have been improving since 2004, when Mohammed bin Zayed – the architect of the UAE’s interventionist foreign policy – became crown prince of Abu Dhabi, the deputy supreme commander of the Emirati armed forces, and, thanks to the poor health of his half-brother, the de facto leader of the country.

Under his rule, relations with Israel went from good to better. (Not even the assassination of a Hamas military commander by Mossad in Dubai in 2010 could shake them.) In 2018, the UAE invited Israeli athletes to participate in Abu Dhabi's Judo Grand Slam and allowed them to display their flag and sing their national anthem.

The Israeli minister of sports and culture accompanied the athletes and was invited by Emirati authorities to visit Abu Dhabi’s Sheikh Zayed Grand Mosque. Last year, news emerged about a secret deal by which Israel would supply the Emirati air force with two sophisticated surveillance planes.

The UAE allowed Israel to have its pavilion at the Expo 2020 Dubai (now postponed to 2021 because of COVID-19). MBZ persuaded Abdel Fattah al-Burhan, the chair of Sudan’s ruling Transitional Council, to meet with Israeli Prime Minister Benjamin Netanyahu in Uganda last February. The meeting allowed Israeli jetliners to fly over Sudanese airspace. As a gesture of goodwill, Abu Dhabi supplied Israel with 100,000 virus test kits last June.

Considering the excellent working relations between the two countries, did the UAE need to sign a controversial peace treaty with Israel?

The answer to that question lies in the understanding that MBZ is a staunch anti-Islamist, a role that has made him a dedicated warrior against Islamists and a champion of the counterrevolutions of the Arab Spring.

Put simply, his search for reliable allies is what prompted him to formalize his relations with Israel.

Selling the Deal

MBZ’s decision to officially recognize the state of Israel violates the conventional Arab wisdom that agreement to establish a Palestinian state must precede full normalization of relations.

Emirati officials claim that they succeeded in averting West Bank annexation and put the Palestinians on the road to state formation.

They add that normalizing ties was necessary to prevent Israel from annexing 30 percent of the West Bank and to revive peace talks for the two-state solution. Many Israelis do not see the UAE as changing the geopolitical reality of the Middle East since it does not obligate them to make concessions to the Palestinians.

They approve of formalizing relations with the UAE because it costs Israel nothing and does not require them to change anything.

Netanyahu insists that the deal with the UAE postpones annexation and does not cancel it. Israel never unequivocally accepted the principle of statehood for the Palestinians, and its remarks on this matter have not exceeded vague lip service. The 1978 Camp David Accords mentioned Palestinian autonomy.

Israeli perception of Palestinian self-determination is limited to self-rule in disjointed semi-autonomous enclaves. In 2019, Netanyahu spoke his mind about this issue: "A Palestinian state will not be created, not like the one people are talking about. It won't happen."

The best that Trump could say about suspending annexation was that "right now it is off the table."

The U.S. ambassador to Israel was more explicit: "It is not off the table permanently." Emirati diplomat Omar Ghobash admitted that his country's deal with Israel does not guarantee that it won't annex parts of the West Bank.

He said, "nothing is written in stone."

He seems to have accepted that the treaty does not give the Palestinians more than "breathing space" to resume the peace talks with Israel.

The Palestinian Authority reacted promptly by recalling its ambassador in Abu Dhabi. It characterized the agreement as treasonous to the Palestinian people. Hamas described it as a stab in the back. Palestinians of different affiliations now consider the UAE’s pretense of solidarity with them insincere and fraudulent.

Arab skeptics took issue with the deal too. Western countries welcomed it despite outright Palestinian anger, sweeping condemnation among the Arab public and, except for support by the governments of Oman, Bahrain and Egypt, eerie Arab official silence.

The True Motives Behind the Deal

The fact is that the agreement is neither strategic nor historic. The UAE claims the deal comports with the 2002 Arab Peace Initiative that proposed full recognition of and normalization with Israel in exchange for establishing a Palestinian state with a capital in East Jerusalem.

The initiative made normalization contingent on Palestinian statehood; the text of the recent deal blatantly neglected to address it.

The principals of the deal – the U.S., Israel, Saudi Arabia and the UAE – had plenty of reasons to move forward.

All of them have problems at home, and all can use a political victory, however superficial: Trump is facing a tough reelection, Netanyahu is facing substantial financial corruption charges, Mohammed bin Salman worries that Joe Biden might question him on Jamal Khashoggi's murder and other human rights violations, and MBZ’s staunch support for Trump could complicate relations with Biden if he wins the contest. (MBZ also has legal issues; a French court is deliberating whether the UAE should be charged with war crimes in Yemen.)

Emirati officials believe that normalizing relations with Israel will give them a security blanket if Trump loses the election and Biden changes course on U.S. foreign policy.

MBS and MBZ think the Jewish lobbies in the West are capable of shielding them from prosecution.

More strategically, the peace agreement is a response to the spread of Turkish influence in the region. Ankara’s ambitious regional policy and pan-Islamic disposition butts against MBZ’s interventionism – and his desire to turn his country into a leading power in the Middle East.

The timing is also notable. MBZ authorized the agreement one week after a rare virtual meeting between the foreign ministers of the UAE and Iran to exchange good wishes on one of Islam's major festivals. It is unlikely that the Emiratis had not tipped the Iranians about their peace plans with Israel.

Relations between the UAE and Iran have improved markedly in the past 18 months. Unlike many, the UAE did not accuse Iran of being behind the Fujairah oil tanker attacks in 2019.

Abu Dhabi provided Iran with much needed COVID-19 testing kits and refrained from intervening in Yemen's Houthi activities.




Ultimately, it’s all about the UAE protecting itself. Indeed, the search for security guarantors is a legacy for the Gulf Cooperation Council countries.

The emirates that came together to form the UAE in 1971 all had protection agreements with Great Britain until 1971. Bahrain, Qatar, Kuwait and Oman signed similar treaties with the British during the 19th century and early 20th century.

In 1915, Ibn Saud signed the Treaty of Darin that effectively rendered his nascent state a British protectorate. The Quincy Pact in 1945 made Saudi Arabia a virtual U.S. protectorate.

Yet they failed to create a unifying political vision and build a capable military force to protect their independence. They engage in centuries-old rivalries and feuds.

It isn't easy to imagine that the UAE, which cannot work transparently and constructively with fellow GCC member states, can work with Israel except as a junior partner.

The UAE has succeeded in carving a niche in the international economic system as a dependent country with a flourishing services sector.

One must not read into the Israel-UAE peace treaty outside this context.