A vote of confidence? Banks start repaying ECB long term loans

This morning saw the start of the on-going process of repayments of the loans given by the ECB to European banks under the Long Term Refinancing Operation (LTRO) (see here for details).

The ECB announced that 278 banks have already pledged to repay €137.2bn. This compared to the 523 banks in total that borrowed around €190bn in net liquidity from the first LTRO at the end of 2011. The amount repaid was above expectations – below we assess why this may have been and what it could mean for the eurozone.

Why have banks decided to repay so much so early?

- A big motivating factor is reputation. It is clear that banks which repay early can highlight that they have access to market funding at low levels and have a sustainable business model.

- Although the loans seem cheap with the low ECB rate they require lots of collateral (to which haircuts are applied). This cost mounts up and some banks (particularly in northern countries) can now borrow on the markets more cheaply. ECB funding is also secured (against the aforementioned collateral) this ties up lots of banks assets, many may prefer to seek unsecured market funding, even if it is a bit more costly.

- Having huge amounts of excess liquidity just parked at the ECB is not efficient or effective. It also distorts bank balance sheets and may detract from other goals such as deleveraging or recapitalisation (more on this in a minute).

What does this mean, if anything, for the eurozone?

- There are fears over a two-tier banking system between those stronger banks funding themselves on the market and those reliant on the ECB. We would add that this furthers the divergence in the eurozone since the split is broadly along the existing strong/weak country divides.

- If the move is to aid banks in deleveraging this could perversely have a negative effect on the eurozone, with banks decreasing lending and reducing demand for euro (particularly peripheral) assets.

- That said the net impact on liquidity is limited, with excess liquidity in the system still at almost €700bn. It may need a further €200bn to be removed before the impact is substantially felt in terms of borrowing costs and demand for assets in the eurozone.

- There could well be a confidence boost from the higher than expected repayment. However, if this furthers a strengthening in the euro there could be growing concerns that it could begin to hamper exports in the weaker economies (a key driver of growth when both public and private sector are limited spending). This also furthers tensions within the one-size-fits-all monetary policy.

So, there are some clear reasons for repaying the loans early, although what it means for the eurozone and the impact it could have is far from clear (this is partly because the actual impact of the LTRO beyond helping banks fund themselves is far from clear). 

One more thing: many analysts are now making a song and dance about the reduction in the size of the ECB balance sheet - seeing it as a great positive. Which it is of course. But strangely, the same people always made the point that the ECB's expanding balance sheet, really wasn't that importance. So which is it?

In any case, as we said at the start, this is a rolling process and the full impact will not be clear for some time. The most important point to watch now is the location of the banks which announce that they have repaid. If it turns out to be solely northern banks, we could see some divergence emerging in the banking system, at just a time when eurozone 'bank union' plans are trying to unify it.

Will the pound really take a beating from the UK's debate on Europe?

Ahead of David Cameron's incredibly hyped speech, a bit of a foreign exchange side-debate has developed with some analysts suggesting that sterling could weaken significantly as talk of the UK leaving the EU increases uncertainty, while the eurozone starts to recover. Are such fears valid?

 

·         As we have pointed out repeatedly in recent days, the debate is not yet about a straight in or out - but whether the UK should seek new EU membership terms.Unfortunately, currency markets (notoriously volatile) may not capture that, even if businesses do.

·         In our view, if you're a currency analyst, there are more important issues that could drive sterling lower than the intensified EU debate, including the threat of a triple-dip recession, loss of the UK’s triple-A rating, continuing to miss debt and deficit targets and the election campaign in 2014/2015. Ultimately, we’d expect currency markets to take the lead from the UK’s wider economic policy than just the UK-EU issue.

·         As we discussed in detail in our outlook for2013, there is still a lot of uncertainty in the eurozone, particularly with the Italian elections and the fact that the structural flaws have not been solved. The ECB is also still providing copies amounts of liquidity with a very loose monetary policy. Although, the latter has helped strengthen the euro at times, we think there is a limit to how far this can go. During the crisis, the repatriation of assets from abroad by banks and firms in the eurozone has propped up the currency, as the situation improves slightly this may slow. These factors combined could cap any substantial strengthening of the euro.  

·         Although sterling has weakened in recent days, other indicators of safe haven flows, such as UK borrowing costs and the London property market, have continued to suggest that there is still very strong demand for UK assets.

·         Given that safe haven flows have continued for some time, sterling may be inflated above where it normally would have settled, as such any change may simply be a correction to the norm as markets turn more positive.

·         Currency strength is significantly determined by central bank action these days. With the US Fed planning to keep policy loose for the foreseeable future (and keen to have a weak dollar) and the ECB of the same mind-set, sterling may continue to be seen as an attractive option. The Swiss National Bank will also have to unwind its massive foreign currency reserves at some point, given that a significant amount of this is in euro it could weaken the currency.

·         In terms of impact on the UK, a weaker pound could aid the UK in terms of boosting exports. However, given our reliance on imports and the fact that a weaker currency could also see an increase in borrowing costs for the UK a decrease in foreign demand for our assets, the overall impact may not be positive. Sterling has devalued significantly since the start of the financial crisis with the boost to exports being minimal.

There is a good chance that sterling could weaken this year, which may not be good for the UK economy. However, the impact of a potential EU referendum in 2-3 years’ time on the currency should not be overstated. There are plenty of other more pertinent arguments to focus on both for the UK-EU debate and the analysis of sterling.