In recent times the European Central Bank has been pushed to centre stage in the crisis in the euro zone. Whilst some central bankers may enjoy the limelight it is true to say that central banks mostly operate in the background and the shadows and only occasionally emerge to explain their policies. Because of the nature of the sovereign debt crisis that has hit some of the peripheral (southern) European countries the ECB has been dragged blinking into the limelight. There have also been two clear examples where the combination of limelight and political pressure has acted to erode some of the ECB’s credibility. The first was when the ECB was pressurised into reducing and downgrading its loan collateral rules essentially for Greece’s benefit only some 3 months after ECB President Mr. Trichet had stated that this would not happen. The second was quite recent when early on Monday the of May it was announced by euro zone ministers that the ECB would begin purchases of euro zone government debt where there were “market disturbances”. Only on the previous Thursday afternoon the ECB council had met to discuss policy and has denied that it had even discussed the matter. The road to Damascus was very short in this instance! Indeed those with longer memories will recall Mr. Trichet claiming back at the height of the credit crunch that the ECB’s policies were superior to those central banks (he meant the Federal Reserve and the Bank of England) who were buying their own governments debt.
These u-turns have placed Mr. Trichet in a difficult position and he attempted to gloss over them in a speech in Vienna yesterday.
To those observers who have recently asked whether we have changed our orientation, I can only assure them that, on the contrary, it is the circumstances that have demanded special actions, and our orientation remains the same.
Nice try but I am afraid that you cannot spin 180% on at least 2 occasions and claim that your “orientation remains the same”.
ECB purchases of government debt: The Securities Market Programme
The Securities Markets Programme should not be confused with quantitative easing. In simple words: We are not printing money. This confirms and underpins our commitment to price stability.
This is the view of Mr.Trichet again from his speech yesterday. Let us examine what exactly the ECB is doing.
1. It is buying peripheral government debt and I would imagine mostly Greek government debt followed by some Portuguese and Irish government debt. So far up until Friday 28th May it has bought some 35 billion Euros of these instruments and it is still buying.
2.Having claimed it is not indulging in a programme of Quantitative Easing the ECB then has to undo the liquidity effects of its operations. You see it gives cash to whoever sells it the government bonds which raises the money supply and is in effect what is called printing money. Accordingly the ECB is undertaking what it calls a “sterilisation” programme to take the money back out of the system. It is going to undertake one of those operations today at 11.30 and according to its website.
A variable rate tender with a maximum bid rate of 1.00% will be applied and the ECB intends to absorb an amount of EUR 35 billion. The latter corresponds to the size of the Securities Markets Programme, taking into account transactions with settlement at or before Friday 28 May.
So it buys the debt and then sterilises its monetary effects. According to the ECB this is the end of the story but not in my opinion as there is a flaw. If you read further down on the ECB website you come to another phrase.
Fixed term deposits held with the Eurosystem are eligible as collateral for the Eurosystem’s credit operations.
I discussed this matter on the 19th May and still feel the same.You see the ECB is committed to regular tenders in its credit operations so in return for these deposits you have guessed it the banks can in effect reclaim liquidity as these Long Term Refinancing Operations have no limit. Oops. So you can in effect exchange the instruments which are supposed to soak up liquidity for liquidity.
There is an element of sleight of hand in the ECB’s policy where it may well be sterilising the short-term liquidity effects of its government bond purchases but the eligibility of the fixed term deposits as loan collateral means that to my mind once banks are used to the system they will in the medium term be able to raise more liquidity.
There is a further impact of this policy and I discussed it on May 11th.
Whilst the ECB looks as though it is reducing any monetary impact of its sovereign debt purchases by sterilisation it remains true that it is in effect reducing the credit rating of its own assets and itself. In some ways this is not so dissimilar to the sub-prime game played in the past is it? Repackage something up and give it an inaccurate credit rating and hope nobody notices….Also its moves are similar to a tax in that sterilisation involves taxing other (prudent) euro-area borrowers to support a government in fiscal distress presumably as a result of imprudence.
As you can see since then my faith in any sterilisation programme has declined somewhat… As to my suspicions about the policy I notice from two speeches also given yesterday that Axel Weber, Germany’s Bundesbank president, and Mario Draghi, Italy’s central bank governor appear to have concerns too.
I sometimes analyse speeches by using reverse logic and I have done this with Mr. Trichets from yesterday. I feel that public speeches are often to claim things that the speakers knows are not true. For example yesterday he spoke of “Credibility” and “financial independence”. My contention is that your stock in such areas moves in inverse proportion to how often you have to mention it!
One area where the policy has had some success is that it has helped reduce sovereign bond yields in the countries in question. For example Greek ten-year government bond yields closed at 7.71% overnight, Ireland at 4.81% and Portugal at 4.68%. These are lower than they were on the 10th May. One piece of bad news for the ECB on this front is the fact that Spanish ten-year bond yields are heading higher again (please see my post of yesterday for reasons for this) and are now 4.26%. The initial effect of the May 10th rescue package for the euro zone had been to reduce Spanish ten-year bond yields back below 4% for example they closed on the 13th May at 3.97%. So soon we may see purchases of Spanish government bonds and this is a more difficult problem for the ECB as she is a much larger economy and bond market than the ones intervened in so far.
I was asked about Italy in a question yesterday and maybe the clock is beginning to tick here too. Her ten-year government bond yields are now 4.14% after a long period below 4%. Again for comparison her May 13th close was 3.91%. If these trends keep up the ECB is going to be busy.
Looking at Spain and Italy has reminded me of another matter. The ECB has not announced how much sovereign debt it will buy. I can explain that one easily, it does not know.
European Stability Review
You might think that the ECB has plenty to keep it busy. However yesterday it also issued its report on financial stability in Europe. It does not make especially pretty reading for several reasons. From its statement comes.
hazardous contagion channels and adverse feed back loops between financial systems and public finances, in particular in the euro area……….although the profile of ECB estimates of the potential write-downs on loans confronting the euro area banking system displays a peak in 2010, it is probable that loan losses will remain considerable in 2011 as well.
It goes on to say that it expects euro zone banks to have to make further write downs of 90 billion Euros in 2010 and another 105 billion Euros in 2011. One of the factors making the ECB gloomy is the rise in long-term interest rates I have discussed above and their possible effects on commercial and particularly bank borrowing. So this report tens to suggest that the ECB is nervous for economic growth in Europe which as various implications. It reminds me of my suggestion yesterday that Spain’e economic forecasts are over optimistic.
There are two major ironies in this report.
1. The ECB threatens withdrawal of its emergency stimulus measures and tells banks in effect to get ready for this whereas in reality in May 2010 it returned to previous and new emergency stimulus measures.
2. The report will raise questions about the health of Europe’s banking sector which is the same sector the ECB is spending a lot of money to support.
The ECB has a difficult path to tread and if you look at its predecessors on the path to Quantitative Easing (QE) the Bank of England (£200 billion) and the Federal Reserve ($1.25 trillion) both talked of sterilisation and then abandoned it. As the ECB’s sterilisation is weak at best it is running at programme that in my view is very little different to QE in that regard.
Where it is different is in terms of credit risk. As I highlighted above it is buying government bonds (Greek) which many investors and players expect which will have to be restructured in one form or another. This leaves an underlying issue. Moving this debt from private-sector balance sheets (banks) to a public-sector one (the ECB) is again exposing taxpayers to financial risks of which I bet they are not aware. Also there is yet another moral hazard for the banking sector not only do they get offered easy money and easy profits but should the taxpayer subsidised trade ever go really badly wrong then the central bank will step in again. I cannot help the feeling that rather than getting nearer to the needed reforms to the worlds banking systems we may in fact be getting further away.