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Monday, June 13, 2011

ECB blues

The Open Europe team has spent a couple of weeks delved into the books of the European Central Bank. Trying to get to the bottom of what's actually on the ECB's books is a bit of a mission, given that the institution is so opaque that it would probably violate the EU's Transparency Directive on virtually every single point.

In any case, last week we published a report cataloguing the exposure of the ECB to weaker eurozone economies. We estimate that its exposure to Portugal, Ireland, Italy, Greece and Spain has now reached €444 billion - €190 billion of which is to Greece. The point being that this is a hidden potential cost to taxpayers of trying to save the euro (as the ECB is underwritten by taxpayers).

The findings stirred things up a bit - and we got plenty of feed back (overwhelmingly positive for trying to shed some light on what is a dense and poorly understood area). Below are some clarifications and remarks in regards to some of the feed back we got - it's a bit long-winded but please bear with us.
  • "The ECB's losses will be shared between national central banks so it won't be a cost to the ECB itself." We heard this from a couple of people but it's actually not countering anything that we're saying. In fact, we're making the very same point in the report. Any losses will always be shared out between national central banks (particularly as it is national central banks that accept the collateral for banks in return for giving credit). There are, however, a few possibilities for how such losses will be shared in practice (either the ECB's reserves can take the hit directly, meaning it will most likely need to be recapitalised, or NCBs will take the hit directly with the ECB technically only shouldering 8% - see p.9 of the report for a discussion on this). But regardless, the cost will ultimately be passed on to taxpayers.
  • "The ECB should be able to withstand losses arising from a sovereign default, even if it needed further recapitalisation by its NCBs." Related to the above, this is the conclusion that an article in last week's Economist, citing our report, seemed to draw. In other words, a Greek default would not wipe out all of the ECB's reserves. Again, as we argue in the report, this is true but is sort of missing the point we're making. "Even" in that sentence is the crucial part. A recapitalisation from NCBs would effectively constitute a cost to taxpayers - which is precisely what we're trying to flag up in the briefing.
  • "The central bank in the country that defaults will take most of the hit". This is what ECB executive board member Lorenzo Bin Smaghi said in an FT interview the other week, seemingly suggesting that the Greek central bank would take most of the hit from a Greek default. As we've argued here, this is implausible. How would the Greek central bank, backed by the country's cash-strapped national treasury, be able to absorb such huge losses? And if it had to face such losses, then bail-out money would have to take up the slack, which again would take us back to taxpayers. And as we note in a letter to today's FT, Bin Smaghi's claim has been contradicted by Dutch executive board member Nout Wellink, who told Dutch television last month that Dutch taxpayers were on the hook for €4bn via the ECB should Greece default (using this as an argument against Greek restructuring). This suggests that the losses would indeed be shared out amongst NCBs. Incidentally, Wellink's projections line up almost exactly with our higher-end estimates for how much a Greek default would cost the ECB (we estimate €65.8bn in total under with the Dutch central bank would be on the hook for €3.9bn).
  • The ECB's "vehement objections to a restructuring may be as much about credibility as its assessment of the risks it faces". This is from the same Economist article cited above and is also probably true, though as we argue in the report, it's difficult to separate the two. As a paper from the ECB (published right before the ECB started to buy governments bonds), notes:
"The perceptions of a central bank’s financial strength have an impact on the credibility of the central bank and its policy. If it is expected that the central bank is not capable of or willing to incur losses, then costly objectives and policies are not credible and the target cannot be achieved or only at a higher cost to the economy. Financial strength helps the central bank to protect its independence, which is a crucial component of credibility."
  • "Other central banks are even more leveraged than the ECB". This is, in essence, what Commission President Jose Manue Barroso said when presented with our findings. Barroso is actually correct. Both the Bank of England and the Fed are leveraged around 50 times (which is itself a bit concerning - but that's a different discussion), compared to the ECB's 23 times (though other central banks such as the Swedish and Swiss ones are only 5-6 times leveraged). The ECB's leverage itself is not as controversial as what's actually behind it, and differs from that of the Fed and the Bank of England in some vital respects. In particular, the ECB's acceptance of risky paper, such as Greek bonds, is effectively transferring risk from investors to taxpayers, and from weaker, debt-challenged euro-zone economies to the richer economies, like Germany's. This isn't what the ECB should be about.
  • "The ECB also bails out banks and governments in a third way". This relates to the discussion regarding the Eurosystem's Target2 system, which some economists, head of the Ifo institute Hans-Werner Sinn in particular, have argued constitutes a separate stealth bailout from the German central bank to peripheral central banks. The impact of the Target2 system is far from clear but we are of the view that it is, at most, looking at the same problem from a different perspective. The argument that these Target2 imbalances have been crowding out lending in the core or funding peripheral current account deficits also seems misguided. This debate will likely rumble on, but ultimately Target2 is a settlement system and as the interbank lending market in Europe recovers these imbalances should retreat (although this could take some time). In the meantime, any losses would still be shared out amongst Eurosytem members as we laid out in our paper. The real risk is still best represnted by the extensive loans which the Eurosystem has made to peripheral banking sectors and the dodgy collateral it has accepted in return.
The prize for the strangest response to our report, however, goes to the Brussels correspondent of Spanish financial daily Cinco Días who (in addition to suggesting that we want to ban Brussels sprout) concluded that the reason for us publishing the report on the ECB's exposure was because....wait for it...we have invested in a massive amount of Credit Default Swaps on Greek debt. In other words, should Greece default, we'd be rich.

Now, if only that was true.

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