IMF weighs in on the debate surrounding the ECB

There’s been another interesting report put out by the IMF today in the form of its ‘Article IV consultation on the euro area’ (essentially an economic assessment of the eurozone).

The IMF was particularly vocal on the role of the ECB stating:

“Because inflation is low and falling, the ECB has room for lowering rates, and deploying additional unconventional measures would relieve severe stress in some markets.” 

They’re not wrong there, any conventional inflationary pressure for the eurozone as a whole is definitely abating. But the policy implications of such a move are important. The IMF itself puts forward some alternatives, including:

Further liquidity provision. This could encompass additional multi-year LTRO facilities, coupled with adjusted collateral requirements, if needed—including a broadened collateral base and/or a lowering of haircuts—to address localized shortages. The associated credit risk to the ECB would be manageable in view of its strong balance sheet and high levels of capital provisioning. Nevertheless, one of the disadvantages of the LTRO facility is that it tends to strengthen sovereign-bank links (see Box 5).

Quantitative easing (QE). The ECB could achieve further monetary easing through a transparent QE program encompassing sizable sovereign bond purchases, possibly preannounced over a given period of time. Buying a representative portfolio of long-term government bonds—e.g., defined equitably across the euro area by GDP weights—would also provide a measure of added stability to stressed sovereign markets. However, QE would likely also contribute to lower yields in already “low yield” countries, including Germany. 

As you’ll notice both recommendations come with clear caveats – strengthening the sovereign banking loop with the LTRO and the fact that QE would need to be spread across the entire eurozone. We’ve discussed both at length on this blog and in our research but a refresher never hurts.

The LTRO has certainly driven the sovereign banking loop much closer, engraining this connection at the heart of struggling economies (far from ideal) while encouraging the nationalisation of financial markets once more. All this prompted the well-known and incredibly complex banking union discussion. The IMF also notes a further problem with more LTROs, asset encumbrance. A complex issue but essentially banks are running short of quality assets to post as collateral to borrow from the ECB (see graphic below). So even if further LTROs were offered they may not be able to take advantage of them. If the ECB went down this route and faced this problem it would have little choice but to widen its collateral rules or reduce the valuation ‘haircuts’ (which decide how much banks can borrow against certain collateral) thereby taking even greater amounts of risk onto its balance sheet.

 
In terms of QE we’d point you to our report from December and the table below. Ultimately, it would have to be a huge spate of QE to provide enough of a boost to the countries in trouble, but that would also create a huge amount of money flowing into countries such as Germany (which is already concerned about an asset and property bubble).

We’ve argued before that a more significant role in the crisis for the IMF wouldn't be the worst thing in the world. Generally it has provided a more realistic assessment of the situation. Unfortunately, in this case, the problems outlined above are only the technical ones relating to a greater role for the ECB, the political obstacles remain almost insurmountable in the short term. As with the UK government, we’d recommend the IMF engage but avoid spending too much time of policies which are politically nearly impossible and technically challenging.