On 28 December 2011, the Eurosystem conducted a large 3-year LTRO (Longer-Term Refinancing Operation) in which banks in the Euro Area bid about €489bn. I covered this in my post Today’s Eurosystem LTRO and I wrote that the LTRO was to help banks meet their funding needs and that they participated in it to roll over existing debt to the financial system excluding the Eurosystem.
My post had some responses having some issues with this but today the ECB released its January Monthly Bulletin which has a section on the bidding behaviour (page 30 of the pub, 31 of the pdf) confirming this:
(click to enlarge)
Some remarks can be made regarding the bidding behaviour in the three-year LTRO. First, the large amount of liquidity obtained by euro area banks in this operation can be viewed as a reflection of their refinancing needs over the coming three years, as shown in Chart A. Measuring the rollover needs over a shorter horizon, for instance over the next six months, even though it captures the large amount of refinancing needed in the first half of 2012, does not fully explain the bidding behaviour. This suggests that medium-term funding considerations may have had a significant influence on the bidding behaviour. Indeed, in addition to assessing the rollover risk faced by banks, it is useful to consider the residual maturity of banks’ outstanding debt. The longer the residual maturity, the lower the risk that banks will need to seek market funding under unfavourable conditions. Chart B illustrates a clear negative relationship between the size of the bids and the residual maturity of the bidders’ debt. This also suggests that funding considerations may have played a major role in determining the bidding behaviour. Second, banks may have placed relatively high bids in the first three-year LTRO as they viewed the operation as attractively priced compared with the prices that could be inferred from the EURIBOR swap curves or the spreads required by the market for bond issuance in 2011.
Overall, the analysis suggests that funding considerations played a major role in the bidding behaviour of banks in this first three-year LTRO, supporting the Governing Council’s view that the announced measures will help to remove impediments to access to finance in the economy, stemming notably from spillovers from the sovereign debt crisis to banks’ funding markets.
In the press conference following the ECB Governing Council decision on monetary policy (to keep the short-term rate targets unchanged), Mario Draghi mentioned that
Let us not forget that in the first quarter of this year, more than €200 billion of bank bonds fall due. So this decision certainly prevented a potentially major funding constraint for our banking system, with all the negative consequences this might have had on the credit side.
Without the LTRO, banks would have faced pressures to redeem maturing obligations by asset sales which could have led to a fall in asset prices, and if the assets were government bonds, it would have increased risks of a self-fullfilling prophecy.
S&P released another document yesterday in connection with the rating action of Eurozone governments yesterday which you can get via it’s Tweet:
click to view the tweet on Twitter
On the political agreements, the release says:
We also believe that the agreement is predicated on only a partial recognition of the source of the crisis: that the current financial turmoil stems primarily from fiscal profligacy at the periphery of the eurozone. In our view, however, the financial problems facing the eurozone are as much a consequence of rising external imbalances and divergences in competitiveness between the EMU’s core and the so-called “periphery”. As such, we believe that a reform process based on a pillar of fiscal austerity alone risks becoming self-defeating, as domestic demand falls in line with consumers’ rising concerns about job security and disposable incomes, eroding national tax revenues.
Two points.
First – yes, fiscal profligacy is not the only source of the crisis. It is typical to give the example of Spain and Ireland – and done by S&P itself – to justify this:
This to us is supported by the examples of Spain and Ireland, which ran an average fiscal deficit of 0.4% of GDP and a surplus of 1.6% of GDP, respectively, during the period 1999-2007 (versus a deficit of 2.3% of GDP in the case of Germany), while reducing significantly their public debt ratio during that period.
There is a risk in making such an argument and even progressives sometimes do so. The error is assuming that the public sector deficit is a proxy for the fiscal stance of the government! Macroeconomists using stock flow coherent macro modeling have shown that the budget balance is just an endogenous outcome and the more appropriate proxy for the fiscal stance is G/θ, where G is the government expenditure and θ is the average tax rate.
To me it seems both Spain and Ireland governments (and local governments) were actually lavish in their spending. The private sector was even more lavish in its expenditure and rising incomes led to higher tax revenues which improved the government’s budget balance before the crisis. The whole process was allowed to continue by market forces, domestic and foreign lenders who (not surprisingly) underpriced risk. Needless to say the lack of a central government overseeing demand management and the ignorance of Keynesian principles contributed to the haphazardness.
Second, most commentators – including the S&P – pay too much attention to price competitiveness. So typically one sees a graph of unit labour costs of individual nations in almost all analysis. One even does not need to take innovations in the export sector to explain the crisis.
The EA17 nations had different levels of non-price competitiveness to begin with and faster growth of income/expenditure in the “periphery” as a result of the boom as compared to slower growth in the “core” nations led to exploding current account deficits. Here’s the data from the IMF’s latest World Economic Outlook published in September 2011 on the current account balances:
With different non-price competitiveness (or income elasticity of imports) (to begin with at the formation of the monetary union rather than innovations during the last ten years) combined with fast rising income/expenditure in the periphery, this led to a dramatic increase in net indebtedness of the periphery as a straightforward consequence. To emphasize the point, even if non-price competitiveness was similar between the core and the periphery, this would have resulted in rising net indebtedness.
It is surprising how international finance contributes to unsustainable processes from continuing as if they can continue forever!
Update
Paul Krugman has a new post on his NY Times Blog on the same comment from S&P from its FAQs but with a different viewpoint.
On 5 December 2011, S&P put ratings of EA17 governments on rating watch negative. See my post S&P And EA17 National Governments for link to the S&P report. Today it concluded its review and downgraded several governments.
click to view the tweet on Twitter
According to the report, which can be obtained from S&P’s Tweet:
We have lowered the long-term ratings on Cyprus, Italy, Portugal, and Spain by two notches; lowered the long-term ratings on Austria, France, Malta, Slovakia, and Slovenia, by one notch; and affirmed the long-term ratings on Belgium, Estonia, Finland, Germany, Ireland, Luxembourg, and the Netherlands. All ratings have been removed from CreditWatch, where they were placed with negative implications on Dec. 5, 2011 (except for Cyprus, which was first placed on CreditWatch on Aug. 12, 2011).
The outlooks on the long-term ratings on Austria, Belgium, Cyprus, Estonia, Finland, France, Ireland, Italy, Luxembourg, Malta, the Netherlands, Portugal, Slovenia, and Spain are negative, indicating that we believe that there is at least a one-in-three chance that the rating will be lowered in 2012 or 2013. The outlook horizon for issuers with investment-grade ratings is up to two years, and for issuers with speculative-grade ratings up to one year. The outlooks on the long-term ratings on Germany and Slovakia are stable.
We assigned recovery ratings of `4′ to both Cyprus and Portugal, in accordance with our practice to assign recovery ratings to issuers rated in the speculative-grade category, indicating an expected recovery of 30%-50% should a default occur in the future.
S&P also cites that “an open and prolonged dispute among European policymakers over the proper approach to address challenges” as one of the reasons to take the rating actions.
How can the Euro Area solve its problems?
One of my favourite papers is A Simple Model Of Three Economies With Two Currencies (link) written by Wynne Godley and Marc Lavoie. The paper was written about 7-8 years back and was published in 2006 in the Cambridge Journal of Economics.
The paper’s abstract:
This paper presents a Keynesian model which describes three countries trading merchandise and financial assets with one another. It is initially assumed that all three countries have independent fiscal policies but that two of the countries share a currency, hence the model can be used to make a preliminary analysis of the conduct of economic policy in ‘the eurozone’ vis-a`-vis the rest of the world—‘the USA’. The main conclusion will be that, if all three countries do indeed operate independent fiscal policies, the system will work under a floating currency regime, but only so long as the European central bank is prepared to modify the structure of its assets by accumulating an ever rising proportion of bills issued by any ‘weak’ euro country.
G&L make an interesting remark about a possible ECB behaviour:
… If the ECB is forbidden from accommodating market-driven changes in the composition of its assets, or if the ECB rules that it will not accumulate additional stocks of securities issued by governments that have excessively large debts according to rating agencies, then fiscal policy in the ‘weak’ countries must be endogenous for stability to prevail, for otherwise it would seem that the only alternative is to let interest rates on euro bills to diverge from country to country in an unsustainable way.
Now this would seem to be a rather dismal state of affairs, from a progressive standpoint. However, it should be noted that balanced fiscal and external positions for all could as well be reached if the euro country benefiting from a (quasi) twin surplus as a result of the negative external shock on the other euro country decided to increase its government expenditures, in an effort to get rid of its budget surplus …
i.e., Euro Area nations with a weak external sector will have to deflate fiscal policy to attempt to keep the external deficit, net indebtedness to the rest of the world and interest rate in check, if surplus nations in the Euro Area do not wish to engage in fiscal expansion. Else, as G&L conclude:
Alternatively, the present structure of the European Union would need to be modified, giving far more spending and taxing power to the European Union Parliament, transforming it into a bona fide federal government that would be able to engage into substantial equalisation payments which would automatically transfer fiscal resources from the more successful to the less successful members of the euro zone. In this manner, the eurozone would be provided with a mechanism that would reduce the present bias towards downward fiscal adjustments of the deficit countries.
In my opinion, this is the only way the Euro Area can come out of the mess because it is the only way the net indebtedness of an EA nation (or a group of nations) can be prevented from exploding relative to its domestic output .
For an earlier take on the Maastricht Treaty by Wynne Godley see the article Maastricht And All That published in the London Review of Books in 1992.
On 8 Dec, the European Central Bank announced that it will conduct two Longer-Term Refinancing Operations (LTRO) with a maturity of 36 months – one each in December and February. According to the initial press release,
The operations will be conducted as fixed rate tender procedures with full allotment. The rate in these operations will be fixed at the average rate of the main refinancing operations over the life of the respective operation. Interest will be paid when the respective operation matures.
The allotment was made today and banks borrowed around €489bn.
The ECB had also given banks an option to shift previous funding:
Counterparties are permitted to shift all of the outstanding amounts received in the 12-month LTRO allotted in October 2011 into the first 3-year LTRO allotted on 21 December 2011.
And according to today’s press release,
The allotment amount of EUR 489,190.75 million includes EUR 45,721.45 million that were moved from the 12-month LTRO allotted in October 2011. A total of 123 counterparties made use of the possibility to shift, whereas 58 banks decided to keep their borrowing in the 12-month LTRO, which has now a remaining outstanding amount of EUR 11,213.00 million.
Another feature of today’s allotment was that Italian banks issued bonds backed by their sovereign and retained the issuance to place them as collateral with their Banca d’Italia – their home NCB for their bids. According to FT Alphaville,
According to Reuters, 14 Italian banks have listed €38.4bn worth of state-guaranteed bonds ahead of the LTRO.
More information:
RTRS-ITALIAN BANKS TAPPED ECB’S NEW 3-YR LOANS FOR MORE THAN 110 BLN EUROS – ITALIAN BANKING SOURCE
RTRS: 14 Italian banks win clearance for state-backed bond issues worth EUR 57-58bln, figure includes EUR 38.4bln already listed – sources
Another reason the auction received so much attention was due to the huge speculation that banks will borrow from the Eurosystem and use it to purchase the debt of their sovereigns and even other Euro Area governments. To me, this is nothing more than speculation because it fails to understand how banks work – the LTRO was to help banks meet their funding needs. It is true that some banks (and only a few) may have done this “carry trade” but it is highly risky and as Megan Greene of Roubini Global Economics put it,
This sort of carry-trade could be extremely dangerous, because it not only fails to break the banking/sovereign feedback loop, it actually strengthens it.
Gavyn Davies of FT had this to say in his blog (which is a fine explanation).
The French government was very explicit that the liquidity injection could be used by banks to buy sovereign debt with a large positive carry. This will almost certainly prove too optimistic, since the banks need the money to redeem their own bonds, not to buy risky debt from sovereigns. Nevertheless, the ECB is certainly preventing banks from selling sovereign debt that they otherwise would have sold, and it is doing this by expanding its own balance sheet. …
In recent posts on the Eurosystem, I looked at how it operates and in The Eurosystem: Part 2 highlighted how capital flow across borders within the Euro Area has led to a large accumulation of TARGET2 balances by some NCBs such as the Deutsche Bundesbank.
If the euro zone breaks into sorry little pieces, Germany could possibly lose its entire €495 billion claim. That’s more than $650 billion. It is 60 percent bigger than Germany’s annual federal budget—and larger than the lending under the European Financial Stability Facility and other aid programs that have received more scrutiny.
Some experts on TARGET2 disagree. So I got into an argument with a blogger (who has a good understanding of TARGET2, btw) according to whom
But let’s take a closer look. Who is this “Germany”? Will the German residents who got their accounts credited as a result of the Target2-facilitated transfers out of Ireland now lose their money? No. There will be no losses to private citizens. Despite all this misleading stuff about “enforced lending”, German citizens will be very grateful that they managed to repatriate their money to German via Target2.
So “Who is Germany”? Hidden in the above quote is that individuals and corporations only make Germany and that if the Euro collapses and hence the European Central Bank goes out of existence, Germany’s Bundesbank’s TARGET2 loss of €465bn (latest data I could get) will be not really a loss for “Germany”. This can be dismissed easily.
According to the IMF’s Balance Of Payments And International Investment Position Manual or BPM6
The IIP is a statistical statement that shows at a point in time the value of: financial assets of residents of an economy that are claims on nonresidents or are gold bullion held as reserve assets; and the liabilities of residents of an economy to nonresidents. The difference between the assets and liabilities is the net position in the IIP and represents either a net claim on or a net liability to the rest of the world.
A nation’s net wealth is the value of its real assets and its net international investment position. This definition has a Mercantalist bias but they have been proven right many times! A loss of Germany’s TARGET2 balance will represent a loss to Germany as a whole. Let us look at this closely with some real numbers.
According to the Bundesbank’s Balance of Payments Statistics, November 2011, (with English translation below)
(click to enlarge)
(click to enlarge)
Germany had assets of €6,158bn and liabilities of €5,209bn and thus a net asset position of around €949bn.
The table columns 26 and 27 show how Bundesbank’s foreign assets have increased recently but aren’t fully updated. Another table from the publication gives the updated numbers.
(click to enlarge)
with the English translations:
(click to enlarge)
So the Deutsche Bundesbank had a TARGET2 balance of €465bn at the end of October and is still rising! This is a sizable fraction of the net asset position of €949bn. (for other comparions, Germany’s 2010 GDP was €2,499bn).
The reason I went through this detail was to help the reader appreciate the question “Who is Germany”. Many breakup scenarios may put Germany at the risk of losing out this huge asset. No domestic transaction will bring this back to the original level.
There are even more dreadful scenarios one can think of. A sudden loss of confidence and a dramatic “flight to quality” will lead residents and foreigners selling foreign assets in the Euro Area (in addition to non-Euro denominated assets) and shifting the liquidated deposits via TARGET2 to German banks and if Germany loses its TARGET2 balance, it could become a net debtor to the rest of the world!
An example will illustrate this. Suppose there is a further shift of €1,000bn before a Eurocalypse. This will lead to Germany’s gross assets increasing from €6,158bn to €7,158bn and liabilities from €5,209bn to €6,209bn, leaving the net position unchanged but increasing the Bundesbank’s TARGET2 position from €465bn to €1,465bn. A potential impairment of 100% implies that Germany’s Net International Investment Position is minus €516bn. All this ignoring residents’ revaluation losses of assets held abroad in such scenarios which will make the whole thing even more disastrous!
The above analysis is for non-residents inside the Euro Area making a financial flight to quality into Germany. For residents, a shift of say €1bn does not increase gross asset and liability positions – as far IIP construction is concerned – but increases Bundesbank’s TARGET2 assets by €1bn with the same effect as above.
In either case – residents or non-residents – Germany’s net asset position is under high risk because of the potential loss due to Bundesbank’s TARGET2 balance vanishing in thin air.
Of course, it won’t be an immediate risk to Germany in the sense that it can go back to the Deutsche Mark and redenominate debts in the new currency and do a fiscal expansion to prevent a loss in output. At any rate, Germany’s wealth which it earned in all these years would have reduced – a Mercantalist’s nightmare.
This is the fifth part of the series of posts on the description of the Eurosystem. In this post, I will discuss whatever I had kept postponing in previous posts – except central bank swaps, which I will postpone to Part 6.
The Euro Area is comprised of 17 nations using the Euro as the legal tender and this is referred to as EA17. In addition, 10 more nations potentially can join the Euro, so they refer to “EU27”. In the recent “summit to end all summits”, European leaders believed in Merkels and worked toward changing the Treaty. UK’s Prime Minister David Cameron refused to sign the new European accord – a wonderful thing to do.
[The UK always had an opt-out option and this move effectively divorces the UK from EU. The other nation with an opt-out is Denmark. The remaining 8 are: Bulgaria, Czech Republic, Hungary, Latvia, Lithuania, Poland, Romania and Sweden. The Wikipedia entry Enlargement of the Euro Zone has good details.]
Before the summit of political leaders, the ECB, in its monthly monetary policy meeting, decided to take steps to improve banks’ conditions: It will now conduct two LTROs with a maturity of 36 months and reduced reserve requirements from 2% to 1%. Other than that, it allowed NCBs to accept bank loans satisfying certain criteria as collateral and reduced the ratings threshold on Asset-Backed Securities. Before this, the maximum maturity of LTRO till date was 1 year.
In the press conference that followed, Mario Draghi, the President of the ECB, dashed market hopes of a more aggressive intervention of the ECB in the markets. The press conference transcript is here. However, analysts saw this as a signal from the ECB to force Euro Area governments into agreeing into fiscal contraction ahead of the summit and still expect the ECB to intervene.
Securities Markets Programme
Back in May 2010, the ECB observed that yields of a few “peripheral” government bonds were rising and it looked as if it could become a “self-fulfilling prophecy” and decided to intervene in the markets. In the ECB’s words, the Governing Council decided to:
To conduct interventions in the euro area public and private debt securities markets (Securities Markets Programme) to ensure depth and liquidity in those market segments which are dysfunctional. The objective of this programme is to address the malfunctioning of securities markets and restore an appropriate monetary policy transmission mechanism. The scope of the interventions will be determined by the Governing Council. In making this decision we have taken note of the statement of the euro area governments that they “will take all measures needed to meet [their] fiscal targets this year and the years ahead in line with excessive deficit procedures” and of the precise additional commitments taken by some euro area governments to accelerate fiscal consolidation and ensure the sustainability of their public finances.
In order to sterilise the impact of the above interventions, specific operations will be conducted to re-absorb the liquidity injected through the Securities Markets Programme. This will ensure that the monetary policy stance will not be affected.
The outstanding amount held (settled, to be precise) by the Eurosystem as on Dec 2 was about €207bn, as per this link.
This has continued to rise in recent months because of rising yields of government bonds with markets suspecting that the public debts of Spain and Italy are on unsustainable territory. So the Eurosystem intervenes frequently and the market participants quickly figure this out.
Who Buys – NCBs or ECB?
Some people have asked me – who buys the bonds: NCBs or the ECB? The answer – I believe – is both. Someone asked me if there are traders in the ECB building at Frankfurt. I do not know – perhaps a few. Someone pointed out that the ECB may be buying using the NCB as its agent. Possible. There’s another question, which nobody has asked me – does an NCB of country A buy government bonds of country B? I think so. Who decides all this is not an easy question!
For example, according to the Banque de France Annual Report 2010, (page 118 of publication, 108 of pdf)
The total amount of securities held by NCBs of the Eurosystem under the SMP increased to EUR 60,873 million, of which EUR 9,353 million are held by the Banque de France and are shown under asset item A7.1 in its balance sheet. Pursuant to Article 32.4 of the ESCB statute, any risks from the holding of securities under the Securities Markets Programme, if they were to materialise, should eventually be shared in full by the NCBs of the Eurosystem in proportion to the prevailing ECB capital key shares.
Assuming, the Eurosystem didn’t need to buy French government bonds till now, (at least till 2010 end), it seems it has purchased government bonds of other EA17 nations.
What about the ECB? Yes. According to the ECB Annual Report 2010, page 223 (page 224 of pdf):
Compare that to the Eurosystem’s consolidated balance sheet item (7.1 below) which was large compared to €17.9bn above at the end of 2010:
Also, according to Banca d’Italia’s Annual Report 2010 (page 224 of publication, 231 of pdf):
“Securities held for monetary policy purposes” was about €18bn at the end of 2010, of which about €8bn was in government bonds under SMP and the remaining covered bonds.
So to summarize, government debt is purchased by all NCBs and the ECB and the NCB purchase is not restricted to purchasing government bonds of the same nation the NCBs are located.
The same is true with the Covered Bonds Purchase Programme. The latter is somewhat equivalent to the Federal Reserve’s purchase of Agency Mortgage-Backed Securities in the United States. Covered Bonds are somewhat similar to Asset-Backed Securities such as MBS; the former are on balance sheet of the issuing bank, unlike the latter which are moved into Special Purpose Entities. The assets backing covered bonds are clearly identified in a “cover pool” and are “ring-fenced” which means that if the issuing bank closes down due to insolvency, the assets in the covered pool will be used to pay the covered bond holders, before they are available to unsecured creditors including depositors. The reason the ECB has chosen covered bonds instead of ABS is because of the strength of the covered bond lobby in Europe.
Emergency Loan Assistance
Imagine the following. A Euro Area country X’s government bond yields are at rising and the bond markets are highly suspicious of the government’s solvency. Banks are also in a bad situation and funds have made frequent flights out of the country. The banks have provided all collateral they had to their home NCB. (To be technically correct, foreign assets are pledged to the respective foreign NCB who acts as a custodian for the home NCB). The government has €8bn of payments to bond holders this week. The government has enough funds deposited at a local bank, so it can meet its obligations. However, most bond holders are foreigners. When the government pays the bond holders, the payment will go through via TARGET2 and commercial banks will run out of collateral to provide to their home NCB.
The above is one way in which banks can run out of collateral and there are other ways in which the government is not the direct reason for the outflow of funds, such as a simple capital flight. For this reason, some NCBs invented a programme called “Emergency Loan Assistance” which may not have been a terminology used in the Treaty. The relevant article which may provide an NCB with this power is the Article 14.4 of the Statute of the ESCB and of the ECB
14.4. National central banks may perform functions other than those specified in this Statute unless the Governing Council finds, by a majority of two thirds of the votes cast, that these interfere with the objectives and tasks of the ESCB. Such functions shall be performed on the responsibility and liability of national central banks and shall not be regarded as being part of the functions of the ESCB.
The situation highlighted above happened frequently with Greece during the past few months. The ELA, however was first used by Ireland in 2010. From the Central Bank of Ireland Annual Report 2010
(click to expand)
The item highlighted “Other Assets” contains the balance sheet item for Emergency Loan Assistance. More below, but before this, it is instructive to look at Liabilities:
(click to enlarge)
So, the Central Bank of Ireland’s Liabilities to the rest of the Eurosystem was around €145bn! – which is indicative of how much funds flew out of Ireland and the amount of stress the nation went through. (Ireland’s 2010 GDP was €154bn, btw). I described how funds flow within the Euro Area in Part 2 of this series.
Back to ELA. Page 104 of the publication (106 of the pdf) describes Other in Other Assets as:
This includes an amount of €49.5 billion (2009: €11.5 billion) in relation to ELA advanced outside of the Eurosystem’s monetary policy operations to domestic credit institutions covered by guarantee (Note 1(v)). These facilities are carried on the Balance Sheet at amortised cost using the effective interest rate method. All facilities are fully collateralised and include sovereign collateral as well as a broad range of security pledged by the counterparties involved.
The Bank has in place specific legal instruments in respect of each type of collateral accepted. These comprise: (i) Promissory Notes issued by the Minister for Finance to specific credit institutions and transferrable by deed, (ii) Master Loan Repurchase Deeds covering investment/development loans, (iii) Framework Agreements in respect of Mortgage-Backed Promissory Notes covering non-securitised pools of residential mortgages, (iv) Special Master Repurchase Agreements covering collateral no longer eligible for ECB-related operations and (v) Facility Deeds providing a Government Guarantee. In addition, the Bank received formal comfort from the Minister for Finance such that any shortfall on the liquidation of collateral is made good. Where appropriate, haircuts (ranging from 5.5 per cent to 80 per cent) have been applied to the collateral. Credit risk is mitigated by the level of the haircuts and the Government Guarantee. At the Balance Sheet date no provision for impairment was recognised.
You can find details of these in this blog post Irish Central Bank Comfort at the blog called Corner Turned, which is now inactive.
Oh yeah … How does the Irish NCB provide the loans? Hint: Loans make deposits.
FT Alphaville has two nice posts (among others) on ELA in Greece: Sundry secret Greek liquidity [updated], Hooray for, erm, Greek ELA?. The first one pokes on how the Bank of Greece – Greece’s NCB – hides the item under “Sundry” and the second one one how Greek banks’ net interest income were higher than expected – the reason being that expensive deposits were replaced by cheaper NCB funding!
This concludes this post. In Part 6 – the final one – I will discuss central bank liquidity swap lines with the Federal Reserve.
Kevin O’Rourke of Oxford University has a post on Project Syndicate, correctly titled A Summit to the Death, in which he nicely summarizes the recent EU “summit to end all summits” held at Brussels. He says
With this in mind, the most obvious point about the recent summit is that the “fiscal stability union” that it proposed is nothing of the sort. Rather than creating an inter-regional insurance mechanism involving counter-cyclical transfers, the version on offer would constitutionalize pro-cyclical adjustment in recession-hit countries, with no countervailing measures to boost demand elsewhere in the eurozone. Describing this as a “fiscal union,” as some have done, constitutes a near-Orwellian abuse of language.
As, FT Alphaville put it appropriately, “Do you believe in Merkels?”
It’s a dark age for Macroeconomics, as Paul Krugman put it – except for a few like Stephen Kinsella (from the Univesity of Limerick, Ireland), who is taking up the challenge of making stock-flow coherent models more practical and using them to come up with policy proposals, scenarios under different policies, etc for the Irish economy. Here’s an interview by INET
For countries in net external liability positions, including the eurozone’s peripheral economies, we see growing risks to the funding of their external requirements. In our view, financial institutions located in countries in net external asset positions (such as Germany) also face pressure where the quality of those assets is deteriorating.
So it seems to understand that the problem of the Euro Area is severe internal imbalances leading to high net external debt.
S&P also wrote an article titled Why Trade Imbalances For Creditors As Well As Debtors In The Eurozone Are Weighing On Growth, a few days back. Available through S&P’s Twitter update
click to view the tweet on Twitter
A wisecrack:
More fundamentally, large imbalances between the 17 member economies remain; after many years of high current account deficits in net debtor eurozone countries, these economies have built up substantial levels of net external debt. Such high levels of external leverage will weigh on economic growth prospects–in both net debtor and net creditor eurozone countries–over the next several years. How imbalances between them are unwound, and under what conditions, could determine the success or failure of policymakers in addressing the European debt crisis.
Australia
More on net indebtedness. Australia’s ABS released its Balance of Payments and International Investment Position, September 2011. It has this chart on Australia’s Net International Investment Position (with sign reversed in their convention):
So around 60% of GDP. Highly indebted nation!
Australia’s debt is both in domestic and foreign currencies and banks have hedged most of the foreign currency exposure hedged using foreign exchange derivatives. Australia’s government has almost zero liabilities in foreign currency.
Some people claim that as long as the debt to foreigners is in domestic currency, it doesn’t matter for some kind of “intuitive” reasons. My view is that while it is true that it is advantageous to incur liabilities to foreigners in domestic currency, my reasons are entirely different. A liability in domestic currency prevents revaluation losses if the exchange rate depreciates. A net indebtedness to foreigners is still a burden. A point rarely understood.
Wolfgang Münchau’s strong views are always worth reading. Here’s from today
Click the above to go to the FT page if you have a subscription. Else you can read it via Business Spectator
Münchau says
With five days to go, the world is waiting for a big political signal. What I fear is a fudge, consisting of a multi-annual fiscal retrenchment, no eurobond, at most a temporary debt redemption instrument. The ECB will provide liquidity measures to stabilise the financial sector, and it will also provide a backstop for the bond markets. But I find it hard to see how Mr Draghi can agree an unlimited guarantee in the absence of a political union and a eurobond. A strengthened stability pact is not a fiscal union.
The way the negotiations are going now, I can see a compromise, but no solution.
This is a continuation of posts The Eurosystem: Part 1, Part 2, and Part 3 in which I went through a description of the payment system TARGET2 both domestic and cross-border and the process of how banks obtain reserves from the Eurosystem.
This post will go into the details of the Eurosystem operations. Like all central banks, the ECB simply targets interest rates, in particular the EONIA – the Euro Overnight Index Average . It is “[a] measure of the effective interest rate prevailing in the euro interbank overnight market. It is calculated as a weighted average of the interest rates on unsecured overnight lending transactions denominated in euro, as reported by a panel of contributing banks” according to the ECB website.
It should be noted outright that at some places in the ECB website, there are claims that it controls the money stock. A closer investigation shows no sign of the ECB doing anything of the sort and this claim is just a rhetoric. The Eurosystem is acting just like other central banks, changing short term interest rates and attempting to impact demand. It is impossible for any central bank to control the money stock. I had two posts on money endogeneity: Horizontalism and More On Horizontalism.
Reserve Requirements
Credit Institutions (banks) have an account at their home NCBs and have to maintain a minimum of 2% of their liabilities subject to reserve requirements. The ECB can change this from 2%, but it has never done this so far. Different central banks have different rules on which liabilities are to be included when calculating reserve requirements. For the Eurosystem, overnight deposits, deposits with maturity up to two years are included and so are debt securities with maturity up to two years. Repos, liabilities vis-à-vis other credit institutions including the Eurosystem, debt securities with maturity greater than two years are not included.
Deposits subject to reserve requirements are remunerated at the rate of the main refinancing operations (MROs).
Needless to say, reserve requirements do not reduce banks’ ability to make loans – since loans make deposits and deposits make reserves.
How do banks, as a whole, get the extra (not excess) reserves after they make loans? Either via Standing Facilities, which we consider next or through Open Market Operations.
Standing Facilities
The Eurosystem uses a corridor system for targeting interest rates. Banks can use the deposit facility and are paid interest on excess reserves and can borrow against eligible collateral under the marginal lending facility. For latter, how much? As much as they can, provided they have collateral. According to an old document from the ECB, saying the same:
So the interest rates on the deposit and marginal lending facilities act as a corridor.
In “good times”, banks will lend all their excess reserves to other credit institutions. Since the Eurosystem is adjusting the amount to reserves to hit its interest rate target, some banks may fall short of reserves which they can easily borrow from other banks. Because of uncertainty, some banks will be driven to the marginal lending facility and the Eurosystem will try to fine tune to reduce this. In may also be the case that the banking system as a whole is left with excess reserves and the Eurosystem may try to fine tune this in reverse direction (and will in “good times”). We will see how this happens in the next section.
For what happens during the day, see the end of Part 1 of this series.
But … the crisis hit, and banks became suspicious of other banks’ creditworthiness and this led to a freeze in the interbank market. Banks were cautious in lending each other and also about their own liquidity needs. Thus, they kept a lot of deposits at their home NCB. So one hears of banks “parking” a lot of funds at the Eurosystem. The following chart from the ECB Statistical Data Warehouse highlights the stress in the interbank markets. The y-axis is in Millions of Euros.
Chart updated 6 Dec 2018, as the previous link was broken.
Before we go into Open Market Operations, a table summarizing the Eurosystem’s operations (from the same document linked above)
Government Deposits
For reasons not clear to me, monetary policy documents do not emphasize an important fine tuning operation – shifting of government deposits between NCBs’ and banking system’s books. Movement of funds into and from the government’s account at its home NCB can cause a lot of errors in forecasting liquidity and can cause fluctuations in the rate at which banks are lending each other overnight. At the same time, if managed sufficiently well, it becomes a good tool for fine-tuning! This link from the ECB’s website has some discussion on this.
Open Market Operations
Via, open market operations, the Eurosystem manages banks’ needs for reserves. It neither controls the money stock in the Euro Area nor controls the amount of reserves in any sense of the usage of the word “control”. It may pursue a non-accommodating or a dynamic policy, where it hikes the interest rate, depending on the growth of the money stock but gone are the days of Monetarism! The Eurosystem is defending its target rate, the main refinance rate, which is usually mid-way between the rates for the deposit facility and the marginal lending facility. In recent times, due to banks’ high credit risk, it has lost control of this.
As per Table 1 above, the Eurosystem categorizes its operations as
main refinancing operations,
longer-term refinancing operations,
fine-tuning operations and
structural operations.
We can also describe them – as done by the “Monetary Policy Implementation” document – as follows:
Reverse transactions: MROs, LTROs, Fine-tuning Reverse Operations and Structural Operations;
Outright Transactions;
Foreign Exchange Swaps;
Issuance of ECB Debt Certificates, Collection of Term-deposits.
Before we get into a description of the above items, it should be made clear from the start, that the reader should keep in mind the similarities and differences between this and the procedures adopted by the Federal Reserves in the United States. As mentioned in Part 1, the Federal Reserve and the banking system can be described as asset-based type, while the monetary system in the Euro Area as an overdraft monetary system. (It should also be made clear that “overdraft” here does not mean national governments have an overdraft facility at their home NCB – they don’t have).
For example, it is easy to confuse MROs and LTROs with the (non-permanent) open market operations done by the Fed. The confusion arises because both MRO/LTROs and the Fed’s open market operations are carried out using repurchase agreements (repos). I will have another blog post on the Federal Reserve procedures, but suffice to say here that the Fed’s repos are more comparable to Fine-tuning Reverse Operations.
Reverse Transactions
As mentioned, earlier banks as a whole in the Euro Area obtain all reserves by directly borrowing from the Eurosystem. An exception is that in recent times, banks have seen their reserves increase due to the ECB’s two programs – Securities Markets Programme and Covered Bond Purchase Programme.
Let us consider MROs first.
Every week, the Eurosystem refinances the liquidity needs of the banking system via this operation. According to the implementation document,
- They are liquidity-providing operations. – They are executed regularly each week. – They normally have a maturity of one week. - They are executed in a decentralised manner by the National Central Banks. - They are executed through standard tenders. – All counterparties fulfilling the general eligibility criteria may submit tender bids for the main refinancing operations. - Both tier one and tier two assets are eligible as underlying assets for the main refinancing operations.
So every week, the Eurosystem lends banks amounting billions of Euros via an auction but these are executed in a decentralised manner by the NCBs as repurchase agreements. (Edit: 21 Dec 2011: A bit incorrect to term MRO/LTROs as “repos”). During the week, funds flow in all directions and banks will borrow from each other.
What about LTROs?
These are almost similar to the MROs, except that they are executed every month and normally have a maturity of three months. In recent times, the ECB has been more accommodative and has offered LTROs with longer maturities such as six months.
Since the frequency of MROs is one week, there needs to be some tool for the Eurosystem during the week to fine tune reserves so that interbank lending rates do not deviate from the target. So Fine-tuning Reverse Operations. These need not have fixed maturities and can be done in short notice but executed in a decentralised manner by the NCBs. About Structural Reverse Operations, I have nothing to say!
Outright Transactions, FX Swaps, ECB Debt Certificates & Term Deposits
In addition, the Eurosystem may employ other tools to provide or remove liquidity such as outright purchases or sales of domestic securities or entering into foreign exchange swaps with financial institutions. These are generally decentralised i.e, executed by the NCBs but the ECB may sometimes be involved. Collection of term deposits and issuance of ECB debt certificates absorb liquidity (i.e., reserves). The former is executed by the NCBs. Debt certificates are settled in a decentralised manner by the NCBs. Another difference between the two is that the former is not marketable, while the latter is.
Conclusion
A bit boring, wasn’t it? Haven’t yet covered ELA (Emergency Loan Assistance), SMP (Securities Markets Programme) and CBPP (Covered Bond Purchase Programme). My aim was to detail out the monetary operations so that we know what the Eurosystem does, what it doesn’t and what it can do (and what it cannot do!). Probably ELA, SMP & CBPP for the last part in the series – Part 5.
Addendum
How does the ECB change short term interest rates in normal times? By a simple announcement. Banks will automatically start lending each other at the target rate. MROs are done weekly, and there will be no additional MRO that needs to be done post/pre the announcement. Neither do fine-tuning reverse operations change in volume because of the decision.
