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    ECB Can Act As A Safety Valve, But Will Not Solve The Crisis

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    Nicholas Ang
    The ECB can provide some support as a safety valve during the Eurozone sovereign debt crisis, but it cannot solve the crisis on its own due to several constraints. While the ECB can provide unlimited liquidity to banks and has purchased some government bonds, taking more aggressive actions like ramping up bond purchases could undermine incentives for reform and raise inflation risks. The ECB also lacks the political legitimacy to circumvent the need for fiscal adjustments by countries. Converting the EFSF into a bank that could use ECB liquidity would not meaningfully change this, as it would still amount to monetization of debt. The ECB will continue limited short-term support and use its independence to pressure governments for reforms.

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    ECB Can Act As A Safety Valve, But Will Not Solve The Crisis

    Uploaded by

    Nicholas Ang
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    The ECB can provide some support as a safety valve during the Eurozone sovereign debt crisis, but it cannot solve the crisis on its own due to several constraints. While the ECB can provide unlimited liquidity to banks and has purchased some government bonds, taking more aggressive actions like ramping up bond purchases could undermine incentives for reform and raise inflation risks. The ECB also lacks the political legitimacy to circumvent the need for fiscal adjustments by countries. Converting the EFSF into a bank that could use ECB liquidity would not meaningfully change this, as it would still amount to monetization of debt. The ECB will continue limited short-term support and use its independence to pressure governments for reforms.

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    63693159 JPM ECB Can Act as a Safety Valve but Will Not Solve the Crisis Research Note 2011 08-26-666075

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    The ECB can provide some support as a safety valve during the Eurozone sovereign debt crisis, but it cannot solve the crisis on its own due to several constraints. While the ECB can provide unlimited liquidity to banks and has purchased some government bonds, taking more aggressive actions like ramping up bond purchases could undermine incentives for reform and raise inflation risks. The ECB also lacks the political legitimacy to circumvent the need for fiscal adjustments by countries. Converting the EFSF into a bank that could use ECB liquidity would not meaningfully change this, as it would still amount to monetization of debt. The ECB will continue limited short-term support and use its independence to pressure governments for reforms.

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    Attribution Non-Commercial (BY-NC)
    Download as PDF, TXT or read online from Scribd
    Download as pdf or txt
    20 views2 pages

    ECB Can Act As A Safety Valve, But Will Not Solve The Crisis

    Uploaded by

    Nicholas Ang
    The ECB can provide some support as a safety valve during the Eurozone sovereign debt crisis, but it cannot solve the crisis on its own due to several constraints. While the ECB can provide unlimited liquidity to banks and has purchased some government bonds, taking more aggressive actions like ramping up bond purchases could undermine incentives for reform and raise inflation risks. The ECB also lacks the political legitimacy to circumvent the need for fiscal adjustments by countries. Converting the EFSF into a bank that could use ECB liquidity would not meaningfully change this, as it would still amount to monetization of debt. The ECB will continue limited short-term support and use its independence to pressure governments for reforms.

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    of 2

    JPMorgan Chase Bank, London Greg Fuzesi (44-20) 7777-4792 greg.x.fuzesi@jpmorgan.

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    Economic Research Global Data Watch August 26, 2011

    Economic Research Note

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    ECB can act as a safety valve, but will not solve the crisis
    The ECB is unwilling to buy peripheral government securities in size or to intervene for very long This reluctance reflects deep concerns about moral hazard, political legitimacy, and inflation risk With Euro area governments still reluctant to significantly enlarge the EFSF or introduce Eurobonds, many are looking to the ECB as the only institution capable of solving the regions sovereign crisis. Some suggest that the ECB should simply ramp up its purchases of government bonds through its Securities Markets Program (SMP), which it could do by creating more reserves (i.e., printing money). However, this strategy would bear huge risks and the ECB has little appetite for following it. Instead, the central bank sees clear limits of its policy toolsit is willing to act as a safety valve against short-term stresses in financial markets but it cannot solve what is ultimately a crisis of fiscal policy and solvency. As a result, the ECB will always force the ultimate resolution of the crisis back to politicians.

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    The ECBs two balance sheet supports


    In response to the stresses caused by the sovereign crisis, the ECB is using its balance sheet as a safety valve in two ways. Unlimited provision of liquidity to banks. Since October 2008, the ECB has been meeting banks demands for liquidity in full. In late 2009, this led to a doubling of the total loans made by the ECB to banks (to ! 900 billion), as the drying up of interbank lending forced all Euro area banks to hold larger liquidity buffers with the central bank. Since then, the pressures have mainly led to shifts in the distribution of liquidity, rather than to increases in the overall amount. In particular, as certain groups of banks (e.g., peripheral ones) have come under pressure, the flow of private funding from bad to good banks has increased the reliance of the former on central bank liquidity and reduced it for the latter. If such imbalances are across countries, they can show up as the infamous ! 325 billion exposure of the Bundesbank to peripheral central banks via the TARGET2 payment system. In effect, the German banks have seen an inflow of private funding (and hence reserves), allowing them to reduce their borrowings from the central bank, while peripheral banks have had to top up their reserve accounts by borrowing more. In this way, the Eurosystem is acting as lender of last resort, given that the interbank market is not distributing funds from good banks with surplus funds to bad banks. Asset purchases. From mid-2009 to mid-2010, the ECB bought ! 60 billion of covered bonds to support this important bank funding market. And through its SMP, it has so far bought ! 110 billion of peripheral government bonds. The ! 35 billion of Italian and Spanish bond purchases have lowered 10-year yields by around 1%-pt in these countries over the past two weeks.
    1

    How big are the safety valves?


    It is not hard to see why some may argue that the ECB could expand its balance sheet much more aggressively in response to the sovereign crisis. The total size of its balance sheet has increased around 50% since 2007, which compares to an increase of around 200% for the Fed. In addition, around 80% of the increase has been driven by the more obscure and inactive balance sheet categories, such as valuation gains due to the higher price of gold and increases of the investment portfolios, which are held partly for operational reasons and as counterparts to the central banks capital. In contrast, the ! 110 billion of government bond purchases make up just 5% of the balance sheet at present. And despite providing as much liquidity to banks as they demand, the aggregate amount lending is not a lot higher than it was in 2007 (although changes in the distribution of this lending matter at least as much as the total amount, see box).

    Why is the handbrake on?


    In our view, there are three interrelated reasons for the ECBs caution. The first is moral hazard. The ECB wants troubled banks to restructure their balance sheets and raise capital so that they can quickly return to private funding markets. And it wants governments to deliver the difficult

    JPMorgan Chase Bank, London Greg Fuzesi (44-20) 7777-4792 [email protected]

    Economic Research ECB can act as a safety valve, but will solve the crisis August 26, 2011

    fiscal adjustments and reforms that will allow them to regain access to market funding. The ECB has also appeared keen to sponsor moves toward greater political union, including sharing of fiscal capacity, as a means to stabilize the region. The ECB worries that it would weaken the incentives for banks and governments to make these necessary adjustments, if it provides liquidity too generously to banks and if it keeps government bond yields too low. It cannot turn off the liquidity tap for banks altogether, as this would cause a banking crisis. But, it is making relatively short forward commitments about providing unlimited liquidity (currently until 1Q12) and is reluctant to lend at long maturities (the six month tender it offered in early August has been described as a one-off). It is also leaning on regulators and the banks themselves to adjust and is still working on a special liquidity facility, which would likely provide liquidity for troubled banks for longer periods but against strict conditions and possibly at a penalty rate. For governments, the ECB has pushed them to take responsibility for stabilizing bond markets and has made clear that its renewed bond purchases are only indended to fill an implementation vaccuum until the EFSF can take over. The second constraint is the risk of inflation. The purchase of government bonds leads to an expansion of the ECBs balance sheet, even if the newly created reserves are subsequently sterilized in the form of one-week fixed term deposits. Recent experience in the US and UK does not suggest any mechanical link between such balance sheet expansions and broader money aggregates, or a destabilizing impact on inflation expectations. But the context in which the ECB is acting is different. The ECB does not see a need for balance sheet expansion to deliver price stability. And with markets questioning sovereign solvency in the region, the ECBs purchases of bonds may increasingly resemble monetary financing of deficits, which the EU Treaty forbids and which Germans fear. If people abandon the euro and move into real (e.g. property and gold) or foreign assets (e.g. Swiss francs), rising asset prices and a falling exchange rate could lead to high inflation. Such behavior may seem unlikely, but it is not uncommon for some German tabloids to issue advice to their readers along such lines. The third restraint is political legitimacy. To some, the ECBs bond buying is a neat way of by-passing the political process that is slowing down the fiscal response to the crisis. This ignores the fact that Germany is dragging its feet for a reasonits population and government think that the bailouts only make sense if the periphery does its homework. The ECB does not have the political legitimacy to purposefully undermine this position by purchasing ever larger amounts of the peripheral bond market, a point made
    2

    How about turning the EFSF into a bank?


    Daniel Gros (CEPS) and Thomas Mayer (Deutsche Bank) have proposed setting the EFSF up as a bank to address its limited lending power. It would fund IMF-style adjustment programs by issuing bonds as normal, but would tackle liquidity crises affecting otherwise solvent states by using the potentially unlimited liquidity from the ECB. Effectively, it would purchase government bonds of the country being attacked by markets and then repo them with the ECB. It could intervene quickly, in size and without having to prefund. Such lender of last support could prevent a liquidity crisis from turning into a self-fulfilling solvency crisis. Nevertheless, there are major problems. In particular, there is no real difference between this scheme and the ECB buying directly. As liquidity crisis are almost always associated with some concerns about solvency, it would not circumvent the need for difficult fiscal adjustments. And that implies the same kind of context, which is making the ECB hesitant about large-scale monetization of debt. Hence, we do not see this as a more appropriate form of large-scale purchases of bonds. this week by the German President Christian Wulff. The SMP purchases (! 110 billion so far) and the liquidity support to peripheral banking systems (around ! 325 billion so far) already imply a huge socialization of liabilities across the region. Should this result in losses for the ECB, the central bank would need to be recapitalized or retain future profits. Politicans in the core countries know that their taxpayers are already on the hook for the ECBs exposures, and are unwilling to sponsor them increasing indefinately. The ECBs actions remain a huge source of support to the region and the central bank is justifying them with reference to its mandate: ensuring financial stability by supporting banks, and delivering price stability by improving the functioning of the monetary policy transmission in the bond market. Its independence, however, is strongly rooted in European treaties, which mean politicians cannot coerce it to ramp up or even continue with its SMP purchases against its wishes. While the ECB will continue to act as a shortterm safety valve against market stresses, it can use its independence to push governments in the right directions setting limits to its interventions in terms of quantity or the duration of time it is prepared to act. And the ECBs reluctance to go all in with a much larger commitment to monetize peripheral bonds reflects a deep tradition of stabilityoriented policy, inherited from the Bundesbank. This means recognizing that central bank liquidity can only buy time but not solve a crisis of fiscal policy and solvency. And it means accepting some near-term stress if it helps to reach a more stable medium-term outcome.

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