Monday, December 19, 2011

The Battle for the heart and soul of the ECB

Open Europe has today published a briefing arguing that the ECB is unlikely to buy the hundreds of billions worth of government bonds required for it to properly backstop the eurozone, following an underwhelming agreement between EU leaders at the summit of 8 and 9 December.

However, Open Europe notes that, contrary to popular opinion, the ECB is already heavily intervening in markets. Through its government bond buying and liquidity provision to banks, we estimate that the ECB’s exposure to weaker eurozone economies has now reached €705bn, up from €444bn in early summer – an increase of over 50% in only six months, raising fresh questions about its credibility, independence and possible losses it may face in the case of future sovereign defaults.

The briefing also notes that other suggested options for boosting demand for sovereign debt – such as the newly announced three year long term refinancing operation (LTRO), due on Thursday – while helping to stem the short-term funding crisis, would also come with the risk of incentivising a weak banking sector to stock up on risky government debt. The ECB would also struggle to conduct ‘Quantitative Easing’ (QE) in the same vein as the Federal Reserve and the Bank of England as any QE would have to be spread proportionately around the eurozone, meaning that Germany would be subject to greater effects of any QE than Italy.

Open Europe concludes that there may come a day when the ECB has no choice but to intervene on a massive scale. However, if so, that will likely be a stop gap on the path to a new, slimmed-down eurozone, and probably following the default of at least one eurozone member.

Key points:

- As things stand the ECB should not, will not and cannot provide the unlimited financial backstop to the eurozone that financial markets seem to be clamouring for. The measures taken at the EU summit on 8 and 9 December are unlikely to supply adequate cover for the ECB to buy the hundreds of billions worth of Spanish and Italian government debt needed to fulfil this role.

- The ECB has taken on large amounts of low quality collateral in return for providing loans to banks, and has seen a massive surge in the number of asset-backed securities it has taken on to its balance-sheet. Though not all of these assets are bad or ‘toxic’, they are extremely difficult to value. At the same time, the number of banks which are becoming reliant on the ECB is alarming and hopes that the functioning of the European financial markets will ever return to normal are diminishing – creating a long-term threat to Europe’s economy.

- Through its government bond buying and liquidity provision to banks, the ECB’s exposure to the PIIGS has now reached €705bn, up from €444bn in early summer. This is an increase of over 50% in only six months and shows how, contrary to popular belief, the ECB is already intervening quite heavily in the markets. It also highlights how the eurozone crisis continues to transfer risks away from private creditors to taxpayer-backed institutions. It remains unclear how the ECB would cover losses in the event of a sovereign default.

- The ECB is likely to continue to keep interest rates low and continue to provide cheap credit to banks despite inflation fears in Germany. Currently, given the global slowdown, the different monetary policy needs of eurozone countries are small enough to paper over. However, this will not be the case for long and as German growth picks up the huge flaws in the one-size-fits-all monetary policy will again be horribly exposed.

- Moving forward, the ECB could offer a liquidity boost to Europe’s economy but little more. The term ‘lender of last resort’ is often misused or misunderstood – the ECB cannot fully backstop sovereign states or return them to solvency. At best it could ease the pressure on illiquid states, but even this depends on the legal constraints on the ECB’s defined role and being seen to give in to political demands that would hurt the ECB’s credibility and independence.

- Even if it can be achieved practically, Quantitative Easing (QE) by the ECB is unlikely to work. Even a €500bn bout of QE – as some have called for – would see only €90bn flow towards Italy, due to the need to spread QE evenly across the eurozone. This would not make a significant dent in Italy’s €1.9 trillion of sovereign debt.

- Alternative options such as the ECB lending to the IMF or lending to banks for them to stock up on sovereign debt, are preferable to direct ECB financing of states, since the IMF and banks can apply some conditions and maintain market pressure for reform, but create hazards and complications of their own without offering many additional benefits.

- Instead of arguing about the role of the ECB, EU leaders should focus on pushing ahead with debt restructurings in the eurozone, despite the ECB’s objections, and formulate a plan for how to mitigate the ensuing losses both on the ECB’s balance sheet and in the private sector. Ultimately, money would be far better used for these ends rather than flooding the eurozone with liquidity and recycling debt – both of which have failed so far.

- The time may come when greater ECB intervention in the sovereign debt markets is unavoidable, but at this point it would be a mechanism to help ease the transition to a new eurozone structure, probably with fewer members and a more clearly defined role for the ECB.

To read full briefing, click here.

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