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Wednesday, November 30, 2011

ECB sterilisation fail

The ECB yesterday failed to fully sterilise its purchases of government bonds under the Securities Markets Programme (SMP).

A quick recap - the sterilisation is designed to remove the same amount of liquidity from the financial system as the ECB introduces from its purchases. This stops the ECB from engaging in Quantitative Easing (QE) and allows it to stay in within its mandate by avoiding financing member states directly. This is done by taking on one week fixed term deposits.

This is definitely a strange occurrence and may have some important follow on impacts, especially if it happens again in the near future. Here are a few of our key thoughts:
- ECB failed to absorb the necessary liquidity to sterilise its purchases of sovereign debt. Its target was €203.5bn but it only succeeded in taking on deposits of €194.2bn.

- The shortfall of €9.3bn is not huge but is large enough to be worrying, especially since it basically amounts to the level of bond purchased over the past week.

- This is not the first time the sterilisation has failed. It did so previously (and to a larger extent) but was able to get back on track. At that time the failure was likely due to banks preference to place liquidity/deposits elsewhere to gain higher returns.

- This failure is more surprising, since in times of uncertainty banks are keen to stash funds within the safety of the ECB.

- So why might it have failed? It could be that liquidity is so short and times so uncertain that banks prefer to keep the funds on hand than commit them to a fixed term deposit of one week. This makes sense given the eurogroup and ecofin meetings today and tomorrow as the situation could change with the outcome of those meetings.

- It is also concerning that given the amount of liquidity that banks are draining from the ECB lending operations, there is still not enough demand for the one week fixed term deposits.

- This all raises questions over whether the ECB is reaching some technical limit for sterilisation. It has long been rumoured that there is a limit to the amount of liquidity which the ECB can suck out of the system at reasonable rates. There could come a point where the banks simply do not have the liquidity at hand to fill such huge need for deposits, especially given that their funding is already spread so thinly during the crisis.

- Future sterilisations will be interesting, since previously the ECB has always rebounded quickly and managed to meet its target.
So, in itself this is not a huge event but it definitely raises some interesting questions. Not least on the debate surrounding the role of the ECB. If some technical limit is reached (from the failure of sterilisations) it will force the issue of whether the ECB can engage in unsterilised bond purchases, essentially QE. At that point, as we have pointed out before, it is likely that the ECB and Germany will have to make a fundamental decision over whether to either continue the bond purchases, abandoning their core monetary principles, or stick to their guns and wind down the purchase programme altogether.

Just another small indication that the endgame for the eurozone may be approaching, as if we didn't have enough already...


Rollo said...

It would be strange idf banks did think that it would be a good thing to lend money to the ECB. The ECB is a bad bank, buying up lots of dodgy assets. I woould put my money anywhere but in the Eurozone.

Denis Cooper said...

If I understand correctly, the ECB has been borrowing money from banks so that it can buy dodgy government bonds which the banks themselves wouldn't want to buy.

Is that correct?

So how does that square with the commitment to "the principle of an open market economy with free competition" laid down in the EU treaties, eg in Article 120 TFEU:

"... The Member States and the Union shall act in accordance with the principle of an open market economy with free competition, favouring an efficient allocation of resources ...".

Is it because the ECB knows better than private investors that helping wastrel governments to borrow more cheaply in order to fund their over-spending is "favouring an efficient allocation of resources"?

But now, as I understand, the ECB can no longer borrow as much from banks as it needs for its interventions in the bond markets, so it has started to create new money for that purpose.

Is that correct?

Open Europe blog team said...

Thanks for the comment Denis.
The ECB isn’t quite borrowing from banks to fund its purchases. It purchases the government bonds using the capacity of its balance sheet. This money goes to the holders of bonds (usually banks in this case) and is therefore an injection of new money into the system. If it stopped here then it would be creating new money essentially. However, to stop this being the case the ECB ‘sterilises’ these purchases by taking the same amount of money out of the system (by taking on deposits from banks). When this fails then, it can be seen to have added new money to the system. This goes against the principles and desires of the ECB and Germany so can be seen as controversial.

In any case, this argument is somewhat semantic since the ECB is providing unlimited liquidity or loans to banks in its usual monetary policy operations. Clearly, taking a bit of money out of the system when you are meeting other demands for money fully doesn’t make too much sense. But it is the veil of proper practice which Germany and the ECB have used to suggest they are not simply creating new money. If it fails they will have to answer some difficult questions over the role of the ECB.

Denis Cooper said...

Well, under UK law money deposited with a bank is a loan to the bank, so if the same rule applies the ECB is in fact borrowing from a bank when it accepts a deposit.