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Thursday, 22 December 2011

Santa’s Grotto at the ECB: Liquidity financing to see banks through mid 2012


Mr Draghi’s really putting his stamp on the ECB’s Monetary Policy. The recent cut in the policy rate by 25 bps was followed today by further monetary easing – it provided a gross €489bn in 3-year loans to over 500 banks in the Eurozone. And this follows on the heel of the ECB’s dollar-swap of US 28bn earlier in the week that has also targeted on-lending to Eurozon banks shut out of dollar financing.

Lets call a spade a spade…this is QE ECB style. And its an impressive signal that the ECB means business and will do much to appease many who have queried the central bank’s agnostic stance in the crisis over the last year – although to be fair the ECB’s  been constrained by the (lack of) a cohesive Eurowide counter-part fiscal zone. And its been a long-time in coming and welcome – both in scope, scale and provisions.

Although the net impact will  be lower at around €200bn, the overall impact will be to greatly reduce the liquidity crunch in the interbank markets and across the Eurozone countries. The issuance is debt and not a TARP-like means  to tackle the solvency issues. As such the aggregate debt will need to be repaid and creates a liability for the ECB.

For many – in particular periperhal country banks – in the Eurozone, Christmas has come early
  1. Not only does the manna from Father Christmas-cum-Mr Draghi ease the immediate funding problems for banks it will be enough to help them see out most of 2012 in terms of financing needs – with many banks needing to redeem maturing bonds that will exceed €500bn. A further QE is expected in Q1 2012 so the ECB has clearly shifted its strategy towards a quasi lender-of-last-resort.
  2.  Recipient banks will be able to, in effect, rebuild balance sheets by standard bank intermediation – although the source of funds is the central bank and not depositors in this instance. 
  3. The ECB will hope that this QE leads to a softening in sovereign debt yields as banks park the borrowed funds with a 1% interest into high-yielding Eurozone sovereign paper, which can yield a scrumptious 5-6% on  Italian paper.
  4.  There is good hope that the policy intervention also leads to at least some reversal in the credit-crunch underway in the Eurozone – although if experience in the UK is any guide, this is not guaranteed and the excess liquidity could be redirected into a temporary surge in asset markets. At the very least it will incentivise banks to reduce the pace of delveraging – and that will be a growth positive for the real economy.

Downsides?
 
5.    The goal – if not shock-and-awe – is impressive in scale and as such it will clearly mean that the quality of the collateral deposited at the ECB may suffer from a true mark-to-value exercise. On the other hand as highlighted in the US and the UK it is entirely possible that the return to liquidity and ultimately confidence in inter-bank lending leads to gains in the value of the collateral.  

6.       Monetary purists will worry about inflationary risk…but lets give the ECB credit, this at least prevents deflation at the very least and a nasty spiral of deleveraging by banks and further compression of output. I rather suspect that the standard focus on money equations may be under stress in this highly unusual part of the cycle – and that velocity of circulation which is assumed to be constant may be reducing, thereby reducing the impact of money growth on inflation.

7.       This and the next QE is not sterilised – essentially the inflation argument above. Actually a  bit of inflation may be no bad thing to deflate some of the real debt away. Whilst Germany will not want to hear this the actual risk of internal inflation is a small risk at this stage.

8.       A more interesting risk will be if things still get worse in 2012-13 and the underlying problems in the Eurozone - sovereign, banking and fiscal co-(mis) co-ordination are not resolved. The ECB’s balance sheet is now significant and will have expanded by a factor of approximately 400% between 2008-early 2012. In the event things do go pear-shaped (standard war game start-up: Greek default in move 1…) then the ECB liabilities will be apportioned to the Eurozone governments…and eventually the taxpayers.

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