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Continuing on the path of the series on the Greek macro crisis I will focus on gross capital formation during the Euro era in more detail, especially in connection with imports of goods. First, let’s start with a breakdown of investment in main sectors since 1990 (as %GDP and not including inventory changes):

Greek Sectoral Gross Capital Formation 1990 - 2011


It is quite evident that dwellings are the principal component of investment, especially during the early times of the 1990’s. This component displayed a large drop in the early 1990’s from 16% to 10% GDP where it settled for the greatest part of the following years with small changes. Only during a very short period in 2006 – 2007 did it climb momentarily to 12.5% GDP. So it seems that no housing investment boom actually happened in Greece after the Euro, although house prices did appreciate significantly. The rest of the investment components show quite steady figures. Transport equipment (which includes shipping) displays significant fluctuations while equipment was stable around 4% of GDP with the exception of 2007 – 2008 when it increased to 4.5 and 5%.

Looking into the figures since 2008 makes the depth of the depression very clear. Dwellings construction dropped from 12.5% in 2008 to 4.7% in 2011 and is projected to reach 4.3% in 2012. Equipment investment went from 5% in 2008 to 3.2% in 2011 and other buildings and structures (which include public works) from 4.6% in 2009 to 3.2% in 2011.

Overall, the deepest drop has been in dwellings, a loss reflected in construction employment as well which has lost more than 170,000 workers (from around 400,000 in 2007). This figure alone accounts for a loss of 8.2% in GDP, more than half  the cumulative 2009 – 2011 drop. Most of the components have now settled to such low figures that just basic capital stock maintenance will allow for these levels to be preserved. As a result, investment (and output in the aggregate) will stabilize mainly due to the ‘zero level bound’.

Relation with imports

What I ‘m interested in this post is how investment components relate to imports of goods. For this reason I will use Bank of Greece balance of payments data to construct imports of goods excluding fuels and ships (as %GDP). Since data availability is thin, only the 2003 – 2011 period will be examined.

Since these are time series data, the first action is to determine which are stationary through Dickey-Fuller unit root tests:

Greece investment components unit root


* I(0) stand for stationary and I(1) for stationary by taking first differences.

As it turns out, the components are not stationary. Transport equipment was not included since imports do not include ships. Trying to determine a suitable regression relationship leads to the observation that most of the components do not appear to be highly significant. One simple yet robust relationship is the following:

Greek investment import regression


* denote 90% confidence interval, ** 95% and *** 99%.

Changes in Equipment and dwellings investment during the previous year are able to explain a large part of the current year change in imports. Both coefficients are large, while the equipment one is also negative, meaning that an increase in equipment investment during one year will lead to a drop in imports during the following one.

Based on the above coefficients we can examine the exact magnitude of the effect changes in investment (in these two sectors) had on imports during 2008 – 2011 (including 2008):

Greek investment imports effect


The total effect was very close to the actual change and explains almost 90% of the total change with dwellings playing a key role. Assuming the Greek economy returns to growth and the above relationship is linear on the upturn as well, going back to long-term figures of 10% for dwellings and 4% for equipment  will lead to an increase of imports equal to 2.8% GDP or close to 3/5 the total drop during 2008 – 2011. A recovery will need to be much more focused on equipment investment (and manufacturing in general) rather than constuction (with the corresponding structural effects on employment) for imports not to increase as much.



I recently came across an interesting paper (from the author of slackwire) on Fisher Debt dynamics of private debt. The basic idea is that, just like public debt dynamics calculations, private liabilities as percentage of income are not only the outcome of savings but a more complicated function of the primary balance (net borrowing – interest payments), income growth, inflation and interest payments. Changes in these factors, limits such as an inflation target or the zero level bound on interest rates play a significant role on the long-term path of the private debt burden (liabilities to income), in this case household liabilities.

The authors used flow of funds data for the US in order to examine these factors more extensively. An initial finding is the fact that savings data cannot be used to gauge on the primary balance. Since savings can be defined as ‘savings = primary surplus + tangible investment + net acquisition of fi nancial assets – interest payments’, debt related factors play a central role, something which is evident in the following graph:

In order to examine debt dynamics the law of motion of government debt is used for private liabilities:

in a reduced linear form:

d is the primary deficit to disposable income (net borrowing – interest payments), i the effective interest rate (interest payments / debt of previous year), growth is the nominal growth in disposable income, π the inflation rate and b private liabilities of the previous year / disposable income. Using this (almost accounting) equation, the contributions of each components can be examined for a period starting during the Great Depression:

*pi is inflation rate

The relevant conclusions are:

  • The Volcker shock is quite evident in the data, with the effective interest rate contribution remaining very high ever since 1980.
  • The 70’s inflation shock was actually instrumental in managing to keep the debt growth in mostly negative territory.
  • Households actually moved to a primary surplus during most of 1980 – late 1990’s. Positive debt movements were the result of high effective interest rates and the disinflation project since 1980.
  • The unsustainable increase in primary deficit during the 2000 – 2007 is very clear. The magnitude of the sustained deficit (the integral in mathematical terms) is almost unprecedented in the data.
  • The tremendous shift of almost 15% in the primary balance after 2007 is impressive. Nevertheless, interest rate and income growth dynamics made the actual debt decrease much lower.

A counterfactual scenario is examined were the primary deficits remain the same as the actual data, but growth, interest and inflation rates are the same as the 1945 – 1980 period. This results in a a totally different debt path, which shows that since 1980 the debt path was mainly driven by ‘Fisher dynamics’ and not profligate households:

The obvious exercise is to perform a corresponding examination of Greek household data. Unfortunately, flow of funds data such as interest payments are not that easy to find, while a reclassification of loan data happened during 2010 which breaks the debt series somewhat. I ‘ve used Bank of Greece data on interest rates and loan amounts in order to proxy the effective interest rate. During 2006 – 2009 households incurred loan liabilities to the RoW, most probably a result of loans in foreign currencies (such as swiss franc) so I do not consider the effective interest rate calculation absolutely accurate. Still, the calculated change is very close to the actual one of debt to income. Due to data availability, only the 2003 – 2009 period will be examined:

The interplay between the relevant factors is more evident in the following graph:

The household primary deficit was very large during the 2003 – 2007 period, around 8 – 9% of income, while income growth was much lower, driving a debt financed consumption. Tight ECB inflation policy meant that inflation was not a significant balancing factor, while the large increase in debt made the effective interest rate contribution larger, even though the nominal interest rate was on a downward trajectory.

Since 2008, the primary deficit moved to surplus (a change of almost 9% of income) Nevertheless, debt change was still positive (5% in 2008 and 0,4% in 2009) because of two factors: The large increase in saving lowered the income growth rate to almost a standstill, while the effective interest rate contribution only dropped by 0,7%. A positive development was the fact that inflation remained positive and was actually quite high during 2008 (due to the oil price shock). As a result, debt to income only stabilized without any actual drop.

In order to better account for the fisher dynamics on debt, one can examine a counterfactual scenario on Greek household debt for 2010 – 2015. As a result of lower ‘debt carrying capacity’ households decide to move into a ‘permanent’ primary surplus of 1% of income in order to pay down liabilities. The effective interest rate is assumed to go on a downward path with the inflation rate stable at a level of 3% (a rather high rate given low internal demand). Income growth is assumed at 2% for 2010/2011 and 3% afterwards since the primary surplus will be a drag on economic growth. This results on a drop of the debt ratio by only 14 points from 70,85% to 56,50%:

Debt dynamics make the drop in the debt ratio very hard and slow resulting in a stagnant and long-lasting balance sheet recession. It is also clear that an increase of the income growth rate from 2 to 3% results in an almost equal increase in the Δdebt. The basic method to espace from a balance sheet recession is higher income growth, growth which can only come from other autonomous sources (government and exports) in this scenario.

One meme often repeated about the Greek ‘tragedy’ is that the large current account deficits during the Euro area were fuelled by equally large government deficits. The profligate state was the source of the increase in foreign claims and made the equilibrium unstable since, given the large share of foreign ownership of government securities, a loss of financing would impact on both the current account (and the ability of the Greek economy to import goods) and the government budget (and the ability of the Greek government to finance deficit spending). In my view, the actual data paint a different picture.

The current account was mainly financed through private sector credit flows. These, very large annual flows, were originated by the domestic banking sector and allowed the private sector to finance an expanding trade deficit. The table below shows data for the period between 1999 and 2007 (when private credit expansion was at its height):

It is quite clear that private credit flow was usually at least twice as large as general government net lending. A simple scatter plot leads to an R² of 0.67:

It’s impressive how low the error term of the computed equation is, meaning that credit flows explain almost all of the current account movement. A similar exercise using government net lending leads to an R² of only 0.17 while the error term is quite large and equal to 3.41.

What seems to have actually happened is that domestic private credit flows financed imports. On a second phase, The Rest of the World (RoW) invested these flows in government securities instead of claims on the private sector. As a result, one can maintain that the expansion of net interest payments to the RoW, mainly in the form of government securities coupon payments, were the direct result of the private credit expansion. In any other case, the relevant securities would have been acquired by the domestic sector and consisted net income, rather than a net outflow.

This is quite evident in the RoW asset flows available in BoG financial accounts:

Although the cumulative current account deficit between 2000 and 2008 was almost €193bn (and another €31bn in 2009), most of it was ‘invested’ by the RoW on government securities, with the residual being only €62bn (and even a negative €2bn in 2009). While in the case of countries such as the USA, the RoW ended up acquiring claims on the private sector (in the form of various ABS paper), in the Greek case the foreign sector kept its ‘investment position’ as claims on the government sector, claims for which a large, liquid market existed and which were the main monetary instruments of the central bank.

In my view, such an ‘equilibrium’ was inherently more stable than an alternative one were the RoW held mainly claims on the private sector. As long as the central bank was determined to maintain stability in the government securities market, an adverse external financing shock could be avoided, something which would not be possible in the case of claims on the private sector, since in that case their underlying credit risk would be elevated due to the economic recession, lower real-estate prices and other factors.

On a related note, summing current account deficits since 1995 up to 2011 leads to a figure of -€276.4bn which should roughly correspond to the NIIP at historical costs. On the other hand, the NIIP in 2011Q4 according to BoG data was -€179.6bn, almost 100bn (48% GDP) lower. Based on historical financial accounts flows, at the end of 2011 the RoW should have held around €113bn of government securities, while the NIIP shows a figure of €71.6bn. The ‘internal devaluation’ has also had an ‘external’ effect on RoW claims.

The Levy Institute released a very interesting report on the Greek economy, authored by its president Dimitri Papadimitriou. It looks at various aspects of the Greek economy since the early 1990’s from a sectoral balance approach which points to the fact that the simple profligate nation thinking is not that close to reality.

Based on the sectoral balances, a nation’s external balance is basically the result of investment minus saving. As long as government saving (surplus/deficit) is roughly steady, a large change in the external balance can only come from a corresponding change of the domestic private sector balance. This seems to have happened in the case of Greece:

It is evident that since the mid 90’s, the government deficit was lowered significantly while the private sector balance moved from a surplus of roughly 10% GDP (reflected in corresponding government deficits) to a deficit which reached 8% at various points after the Euro introduction, a change of more than 15% of GDP. This was the driver of the large external deficits rather than the government deficit which did not change much until the 2008 crisis.

Since the private sector balance is defined as S – I, one has to examine both components. Starting with investment we can reach some important conclusions:

  1. There’s no construction boom evident. Rather, ever since the mid-90’s construction investment has been lower and remained quite steady between 13-15% of GDP.
  2. The increase in investment is driven by an increase in equipment purchases which almost doubled after 1995 from 4% GDP to 7.5% and even 9-9.5% in 2007/2008.

The increase in equipment investment can only be regarded as a positive development since the construction sector falls in the non-tradable category, while new equipment will allow higher production and productivity growth in the industrial, tradable sector.

A scatter plot of the real change in imports of goods and transport and equipment investment tells the same story:

Actually if one takes a look at the goods deficit minus equipment investment he ‘ll find that the balance was declining after 2000 and only increased after the oil shocks of 2006 and later:

The clear conclusion is that unsustainable investment did not seem to be the driver of the goods deficit after the Euro introduction. Nevertheless, the strong deterioration between 1995 and 2000 of roughly 4% GDP which is evident in the diagram requires an explanation. If one looks at the trade balance components and private sector saving the driving force is clear:

Household saving went from +8% GDP in 1995 to -4% in 2000 (a change of 12%) with the manufacturing deficit increasing by 4% GDP in the same period. This negative balance persisted up until 2005. So it seems that the actual deterioration in the trade balance happened before Greece entered the Euro with the latter helping the private sector to persist its negative balances without consequences.

One can wonder at this point if, despite low domestic savings, Greece could have taken advantage of the strong international economic growth in order to increase its exports and thus improve the trade balance. In this context the evidence is rather mixed. It seems that Greece REER actually followed the Euro rate, while Germany embarked on a ‘devaluation’ path through steady ULCs:

The  following diagram shows that Greece kept its market share since 2001 and more or less took full advantage of world trade growth:

An excellent IMF study of Euro Area Imbalances provides some useful thoughts on the periphery trade balances:

  1. The lion share of the appreciation between 2000 and 2009 was accounted for by the nominal appreciation of the euro vis-à-vis other currencies, even for the countries such as Greece and Portugal that entered the euro at a potentially overvalued real exchange rate.
  2. The rise of China generated strong demand for machinery and equipment goods exported by Germany while exports from euro area debtor countries were displaced from their foreign markets by Chinese exports.
  3. The term of trade shock associated with higher oil prices contributed to rising trade deficits but higher income in oil producing countries also generated strong demand for machinery and equipment exported by Germany.

In the case of Greece High and Medium-High technology manufacturers account for 20% of manufacturing while in the case of Germany these account for 55%. Manufacturing accounts for 55-60% of goods exports while food still accounts for 20%. So it seems that Greek production was just not in high demand, while China and the oil shocks, helped by the REER appreciation, pushed imports higher without a corresponding increase for exports (in contrast with the German case). Lower ULCs would have probably helped in the import side but not much in the export side, except if they made Greece an FDI target.

Turning away from the goods balance, one has to remember that the balance of payments also includes other important components:

Net transfers and property income seem to have contributed as much as the goods balance since they went from a combined 10% surplus in 1995 to a deficit of more than 5%, especially after 2005, a change of 15% GDP.

A significant part of net transfers balance change is probably attributed to the large inflow of immigrants to Greece after the mid-1990’s, moving the corresponding balance to deficit:

In the case of property income, large external deficits did not adjust through the exchange rate (as during the drachma era) but were accumulated as claims of the external sector leading to large interest payments:

These claims were held by the Euro debtor countries while the rest of the world held claims on the latter and not the periphery. Both movements should be considered ‘structural’, since they are inherent features of a monetary union and of a country rather open to large (legal and illegal) immigration flows.


  1. Greece saw a structural negative change in net transfers and property income balances which will probably persist in the future.
  2. Investment seems to have been a positive contributor since it was targeted towards equipment and not to non-tradable sectors such as construction.
  3. The features of a monetary union allowed its Net International Investment Position to deteriorate with the external sector accumulating claims on Greek residents (government and private sector).
  4. Production was targeted on food and low technology manufacturing sectors and lost ground to China, other Asian EMEs and Eastern Europe countries.

As the IMF acknowledged in its latest WEO, internal devaluation projects utilizing fiscal consolidation are self-defeating in the current environment due to very large fiscal multipliers. Eurobank Research also published a similar research note which found a government spending multiplier of 1.32 and a wage multiplier of 2.35.  2013-2014 measures are projected to lead to further output loss of €15-20bn (7.5-10% GDP). Any positive developments on the trade balance mainly come from demand destruction, while low internal demand, large long-term unemployment and negative bank credit conditions make investment actually the most negative component in real GDP growth. An impressive statistic is the fact that the Total Factor Productivity index for Greece will drop to 100.4 in 2012, down 11.1% from 113 in 2007, back to the 2000 levels. That will limit potential growth and require much more intense usage of other factors (labour and capital) in order for the country to achieve positive growth.

The strong deterioration in the NIIP has been spread throughout the economy, with no sector having a high positive net balance with the rest of the world:

As a result, Greece cannot lower its external debts by moving net financial assets from the private to the government sector (most of the positive ‘other sectors’ balance is due to low Greek equity prices held by foreign investors). Unless a strong policy of economic growth is adopted (through financing by the rest of Europe), the only way out for Greece, as long as it keeps with the current fiscal consolidation policy, is to literally move real resources to the external sector. Since the NIIP is now close to 105% of GDP and property prices in Greece are in considerable fall, even that alternative requires very large transfers.

I ‘ve recently received a few questions about the workings of QE so given the opportunity i thought it would be useful to analyze a few basic facts about quantitative easing in one post.

QE is basically an asset swap since the central bank operates in the secondary market. A long-term (high duration) asset is replaced with a deposit at the central bank (low duration). The balance sheet size of the seller does not actually change. The only wealth effect is any price appreciation of the corresponding asset which happens due to the purchases by the central bank. It works by:

  1. Strengthening the commitment by the central bank to low long-term rates, which should allow borrowers to lower their outstanding debt costs and any new loan interest rates.
  2. Removing duration from the market. Since certain investors are always long duration (such as pension funds) this increases the demand for remaining assets, lowering their yields.
  3. Removing safe assets from the market. Since the new assets (bank reserves at the central bank) cannot be rehypothicated, QE increases the demand for remaining safe assets (dependant on supply such as fiscal deficits).

In modern fiat monetary systems, with central banks employing a corridor system for setting interbank market interest rates (the interbank interest rate is floored by the deposit rate on bank reserves and cannot go over the marginal lending facility), which can be as narrow as they choose, the quantity of bank reserves can be set ‘exogenously’ in order to provide for bank liquidity needs as well as to steer long-term interest rates.

Banks do not need excess reserves in the central bank to lend to the real economy. They create a liability (deposit) whenever they provide a loan (asset) to the private sector. They could always use the same security to get cash in the repo market or by the central bank. Excess reserves are only used for interbank payments anyway and are never ‘lent’ to the private sector. M1-3 is (private) bank money, non bank private sector can only hold central bank (high powered) money in the form of currency. The latter is demand driven and the central bank will always cover the demand for currency by performing outright purchases of government securities (and priting currency leads to a debit of the bank reserve account of the bank that requested the additional ‘shipment’).

In order for the central bank to lower the opportunity cost of increased excess reserves it sterilizes QE through one of the following forms:

  1. By paying Interest on Excess Reserves. This is either equal to its target rate (Fed) or lower (ECB, through the deposit facility). So the Fed does sterilize its operations since banks are indifferent between lending in the Federal Funds market and keeping excess reserves (in reality, due to the fact that GSEs do not earn IOR the federal funds rate is lower than the Fed IOR and provides an arbitrage opportunity).
  2. By providing term deposits which is the main mechanism used by the ECB.
  3. By providing debt certificates, a mechanism that i would prefer for various reasons (see here).

As long as the sterilizing rate is lower than the central bank target rate, QE will drive the interbank rate closer to the deposit rate and the central bank will lose some control over the interbank rate (but can still steer the interbank rate with as much presisionl as it wants by increasing the deposit rate).

By lowering long-term rates a central bank also depresses the exchange rate, a fact that can be strengthened through carry trades. It might also ‘export inflation’ by inducing EMEs to lower their own rates in order to avoid appreciation of their own currencies, thus fuelling credit booms in their own countries. Lastly by making real rates negative it pushes investors to alternative investments such as gold and commodities which might end up in an push inflation cost on recovery. It is a well known fact that the price of gold appreciates when real interest rates are negative:

Low yields on safe assets induce market players to move to riskier assets, depressing their yields as well. As a result, spreads on corporate bonds are reduced and QE is considered bullish for stock exchanges. On a long-term path though, valuations will be based on macro developments than portfolio rebalancing.

As long as the central bank buys from bank clients (and not from banks themselves), the banks end up with an increased balance sheet which might hurt their planned leverage ratios.

In the Eurozone case, investors can select between assets to invest liquidity (in contrast with the US where the only safe asset is US Treasuries). In such a case, outright monetary operations targeted on specific issuers can lower their yields and provide for a buyer of last resort. Whether they will be effective in the long run will depend on:

  1. Macro developments and
  2. If the ECB remits profits to the issuing country and rolls over maturing paper. If it does not then it should be considered as an ‘investor of last resort’ instead of a creditor and it mainly moves the credit crisis into the future when its holdings mature.

A recent post by Ramanan illustrates some quite important accounting facts about Target2 claims/liabilities and relevant Net International Investment Positions (NIIP) which are not always taken into account when analyzing Eurozone imbalances.

People tend to take a simplicit view that German Target2 claims actually represent net claims of the German economy on the rest of the world. In reality, Target2 claims/liabilities are just the accounting entry where assets and liabilities between Eurozone central banks are recorded and do not necessarily represent a net IIP claim. What they really represent is up to what point German claims are accounted as claims on the official central bank sector instead of the private sector. Let’s use two examples to illustrate this point:

  1. A German bank holds an asset on a Spanish bank (a repo loan or a covered bond). On maturity the German side decides not to renew the contract and moves the funds to Germany. BdE funds the transfer by providing liquidity and Bundesbank increases its Target2 claims. The NIIP has remained unchanged with the asset moving from the private sector (a claim on a Spanish bank) to the official sector (a claim of Bundesbank on the ECB which is accounted as a liability of BdE).
  2. A Greek retail depositor fears that his money is not secure in the Greek banking system and moves the funds to a German bank. Bank of Greece funds the transfer by providing liquidity and Bundesbank increases its Target2 claims. The German economy has acquired both an asset (Target2 claim) and a liability (deposit of a foreignor) which means that its NIIP did not change.

In reality, the NIIP changes through the German current account surplus since that is when the German economy acquires net claims on the RoW. On the other hand, the Target2 balance can change by a large amount through shifts in portfolio and other investment, either by German residents or even by foreign residents (who move funds to Germany).

As long as Target2 claims increase through the above two mechanisms instead of current account surpluses, the overall claims will grow without a relevant increase in the NIIP. The mix of private and official claims will change with Target2 claims even growing to become larger than the NIIP. It is clear that in such a context, Target2 claims are actually a risk for the German economy since one or more Euro exits will reduce its foreign claims (either through a default or revaluation to the domestic currency of the corresponding exiting country Target2 liabilities) and can even lead to a negative NIIP as long as Target2 losses are significant.

The table below shows current NIIP for the Bundesbank, which stands at €1014bn for 2012Q1 (NIIP is contained in the ‘Saldo’ column):

Current (August 2012) Bundesbank Target2 claims stand at €751bn, or 75% of the NIIP. For comparison, they were €463bn in December 2012 (or 50% of the 2011Q4 NIIP). As long as the current Eurozone crisis continues, it is quite possible that during the rest of 2012 or in 2013, the German Target2 claims will be larger than the NIIP. At that point Germany will really have to decide if the Euro is actually irreversible or not and take the appropriate actions. In such a context, having a country exit the Euro, even if that country is Greece poses a serious danger for the German hard earned NIIP since it will increase the flow of funds to the core and exacerbate the Target2 risks while leading to a possible loss on Target2 claims on BoG.

In order to protect its claims Germany will quickly have to make some difficult choises, either to accept a serious and large risk or take the necessary steps for an integrated Europe.

I’ve already touched a bit on the subject of how the periphery sovereign crisis (and economic recession/depression) impedes the transmission of ECB monetary policy. Since reactivating (in one form or another) the SMP seems like a real possibility i ‘d like to make some comments on how it is implemented by the ECB.

The original idea was quite reasonable: Provide a distressed bond market with a buyer of last resort who has unlimited firepower and can move prices back to equilibrium. Nevertheless, after the Greek PSI, it became clear that the ECB was determined not to accept any haircuts on its claims and would just let its holdings mature with the sovereign having to borrow from other sources (EFSF/ESM or raise taxes) in order to pay maturing bonds, thus effectively subordinating private bondholders and increasing their haircuts.

If the ECB wants the SMP to be effective it must either accept haircuts on its portfolio (at least as large as the purchase discount) or rollover its holdings. If it requires to be paid at par on maturity (by someone else) it does not relieve any pressure on current holders since they are afraid that they will not be paid at par when their holdings mature. As a result, bond purchases only provide an exit strategy for current holders to dispose of their bonds without prices falling too much, a very short-term support for bond prices.

In my view what is needed is for the ECB to act in the same manner as the Fed. Since it regards the SMP as securities held for monetary policy purposes then it should maintain its portfolio as long as the monetary transmission channel is dysfunctional. It could even use the SMP portfolio to match banknotes in circulation, although such a strategy might hurt its profits in the long run (as long as banks have to borrow from the ECB to cover banknote demand). That would require the following:

  1. At a security’s maturity the ECB must place a non-competitive bid for an amount equal to its holdings at the auction of the bond that will rollover the maturing one.
  2. Rebate interest income (interest paid by the security – cost of SMP fixed term deposits) to the issuer. The most straight-forward way is to use the funds to make non-competitive bids in auctions (for bonds of similar maturities).

I know that the above would probably be regarded as monetary financing by the Bundesbank but it is the policy currently used by the Fed which is also not allowed by law to provide overdrafts to the US Treasury or participate in primary auctions as a bidder.

One additional step in the right direction of equalizing bond yields would be to also use the ECB debt certificate idea. The ECB should ‘sterilize’ its purchases by issuing short-term debt certificates. These would increase the supply of short-term safe assets (these mainly consist of zero coupon paper by Germany, Finland, Netherlands and probably France) which are in high demand, especially after the ECB zeroing of the deposit rate. That should probably push AAA short-term securities yields a bit higher by removing their liquidity premium:

Since Friday, Spanish bond yields are clearly over the 7% threshold making market access and debt sustainability a challenge. I ‘ll take the opportunity to look into more details on the Spanish balance sheet regarding other residents.

The first table includes main liabilities to RoW based on BdE balance of payments data which are only available till 2012Q1 (they will be updated on 31 July):

What is clear is that the main driver of capital flight is a drop in securities investments. Money market instruments also show a large drop, mainly in the general government sector, although the relevant positions were already quite small. In my view this is a clear case of an asset class not being considered ‘safe’ anymore (in the Gary Gorton terminology) with investors moving out of it. Both the Spanish government and economy are now viewed as a higher credit risk instrument, with funding dropping both in the bond (Held to Maturity) and money market areas.

The same is evident if one looks at monthly flows of direct investment (with portfolio investment being the one mainly hurt):

Things are much clearer by looking at more specific data from the BdE (balance sheet data for the BdE and credit institutions), as well as the Spanish Treasury:

The first observation is the significant drop in RoW deposits in credit institutions, deposits which should mainly be considered as part of money market funding. The drop in securities liabilities is much lower than the one observed in the balance of payments data, suggesting that resident banks found new domestic sources of funding (most probably with the help of BdE).

On the government debt front, Treasury data show a large drop in RoW (permanent) holdings, which is covered by an increase in holdings by domestic credit institutions. By subtracting the Net position from the outright holdings, one can calculate the outstanding repo funding from the RoW. Repo funding reached a high in September 2011 but has dropped significantly ever since, especially during 2012. This is another indication of elevated counterparty/collateral risk which leads to a large ‘haircut’ in funding.

Adding up the drop in outright holdings and repo transactions, a large part of the external position (and target2 liabilities increase) deterioration can be explained by foreign investors moving away from the Spanish bond and repo market. The repo/money market drawback is evident in the balance of payments other investment data as well:

Clearly a warning sign is the large decrease in turnover in the outright transactions (bond) and repo markets since February. This was the main pattern observed in the Greek case, with outright trading coming to a halt and price discovery moving to the CDS market with bond yields following CDS spreads (instead of the opposite) since the derivatives market became the most liquid. One thing to keep an eye for is the CDS net notional. If that starts dropping with opposite movement in the gross notional that will mean that market participants are not creating any new net contracts (which ultimately require a short position on the underlying instrument) but only leverage existing contracts by shorting CDS while covering the position with an older long position. This would indicate an unwillingness to take the original credit risk and a difficulty in covering a short position in the bond market. The intermediation trade is probably a nice arbitrage trade since collateral will be provided by the original seller or the new buyer of the contract (depending on how CDS spreads move).

This chart for the Spanish CDS net notional (from ftalphaville) is not good. Current gross/net notional is $171.6/13.7bn while they were $163.2/13.9bn a month ago.

A positive number is the total government deposits available which stand at a little over €90bn. Given the current government debt redemptions schedule and net funding needs, the government does have some leverage in the short-term until probably October (when redemptions are €27.4bn), even if it cancelled all new auctions (except for T-Bills) since most of the redemptions actually concern t-bills (which i think can be covered by domestic credit institutions in any case). With that in mind, i don’t see an immediate reason for a full bailout, at least not until the ESM is allowed to be activated by the German constitutional court in September (since financing through the EFSF for sovereign needs would mean removing the Spanish guarantees). One can probably safely acquire (outright or as collateral in a repo transaction) any debt maturing until October.

Quite a lot of people (including ftalphaville in numerous occasions) have pointed out lately that the Euro crisis is largely a loss of confidence on periphery ‘safe assets’ (safe assets defined as per Gorton 2012). That is something i ‘ve already tried to touch as well in an earlier post.

The loss of safe asset status for an asset class (such as long-term Spanish sovereign debt) has a number of (well known by now) consequences:

  • Local banks usually carry a large portfolio of such assets in their balance sheets, especially compared to their capital base. As a result, their credit status/rating is lowered and their access to sufficient and cheap international funding impaired.
  • The loss is associated with larger haircuts and/or drop in price for the corresponding debt instruments. Consequently, secured loans made with these assets as collateral face large margin calls and the credit multiplier is lowered (since rehypothecation is reduced due to large haircuts). In general, interbank credit volumes face immediate and strong declines.

The approach taken by the ECB to cope with this problem so far has been mainly to provide long-term liquidity, with the central bank reserves performing the function of safe assets. Collateral rules in the 3Y-LTROs have been relaxed considerably, allowing banks to post average quality credit claims (non-securitized loans) in order to obtain funds. This has the significant advantage that, since credit claims are not assets traded in a secondary market, no daily mark-to-market valuation is performed and liquidity provided is kept stable with no price shocks reinforcing the liquidity issue (through margin calls). Still, (1) the ECB takes the role of ‘market maker’, (2) since unsecured lending is limited in the current environment bank reserves are not rehypothecated (reducing the interbank credit multiplier and forcing a large ECB balance sheet expansion to compensate for it) and (3) unsecured bank debt holders are effectively subordinated by the central bank increasing its holdings of European bank assets.

During the 2008 financial crisis, the Fed implemented the Term Securities Lending Facility as a way to ‘upgrade’ assets pledged by credit institutions and keep interbank markets functioning. The general idea was that banks would post low quality paper as collateral and receive high quality (US Treasuries) assets as a short-term loan which they could use in the interbank repo market. As a result, the Fed managed to keep the repo market going, avoiding further drops in loan activity as well as remove a large part of low quality collateral from the active market (by taking it temporarily on its balance sheet).

Since 2010, the ECB has created a large (around €200bn) SMP portfolio of sovereign debt. Unfortunately, the Greek PSI experience showed that it considers its holdings as senior to other bondholders which makes any future purchases more of an exit strategy for existing bondholders, than a stabilizing mechanism. I ‘d like to propose a way for the ECB to take advantage of the fact that its portfolio is considered ‘safe’ (although consisting of periphery sovereign debt) while supporting the Euro repo market.

Debt Certificate

The ECB should create a ‘short-term debt certificate’ (stdc) backed by the face value of the SMP portfolio. The debt certificate should have a low maturity of  one month and pay an annualized interest rate equal to the ECB deposit rate. One of the reasons for keeping the maturity short is for the ECB to avoid disclosing the details of its holdings (something that it seems to be reluctant to do).

The other reason is that the proposed loan will have a tenor of one month. Banks would provide sovereign debt securities of the same type as the ones held in the SMP portfolio as collateral on a monthly debt certificate auction with a maximum size equal to the available amount of debt certificates. The auction would determine the interest rate paid by all banks to the ECB for holding the stdc (it is probably better for banks to be able to place multiple bids). Risk management by the ECB would be the same as always, with daily mark-to-market valuation of posted collateral and margin calls if needed. Settlement of the loan will be done before the debt certificate so that, as long as there is no default on the loan, the certificates do not mature in the hands of the public.

As the semi-annual European repo survey shows, roughly 50% of total repo activity is concentrated in maturities up to one month. I think it is quite reasonable to assume that troubled banks face even shorter tenors and mainly borrow overnight or weekly. As a result, the stdc would provide a handy ‘risk-free’ instrument to use in the majority of repo trades, lowering volatility, haircuts and ECB market making. An expansion of the SMP portfolio would become a stabilizing factor since it would allow for even more safe lending in the repo markets while also moving risky assets in the ECB balance sheet.

In case of a bank default, the ECB would end up with sovereign debt while the bank repo counterparty with the stdc. On maturity (of the stdc) the ECB would credit the holder with an equal amount of bank reserves and would place the sovereign securities in its SMP portfolio, making the default functionally equivalent to an expansion of the SMP.

Given that a bank always has the alternative of using the ECB refinancing operations to acquire funds, the ECB MRO rate should act as a maximum rate in the debt certificate auctions (technically the MRO – Eurepo GC rate). The debt certificate facility should lower (or even eliminate) periphery liquidity premium spreads since any sovereign debt instrument can be posted to the ECB auction. On the other hand, the facility cannot be of real help for credit spreads and sovereign solvency.

SMP management

Another (a bit more far fetched) proposal is for the ECB to start managing its SMP portfolio in the same manner as the SOMA account of the Fed. In other words it should consider its holdings permanent and be allowed to bid with non-competitive bids on sovereign debt auctions (of the same issuer as maturing securities) in order to be able to maintain its portfolio size. That would immediately make the SMP a stabilizing factor since on maturity the ECB would not expect to get paid but would rather rollover its holdings. The fact that something like that would probably be considered as monetary financing is a limiting factor for acceptance.

Since we are on the subject of ‘science fiction’, another proposal is for the ECB to immediately remit all profits produced by its SMP holdings (interest paid by securities held minus cost of SMP weekly term deposits) to the corresponding countries Treasury accounts. Depending on institutional arrangements, this could happen quarterly or annualy and peg the cost of SMP for sovereigns to the average of the ECB SMP term deposits rate.

The last couple of days have seen a large increase in the overnight eurepo rate, which has grown from 0.145% on 26 June to 0.194% today.

On the other hand, the 1-week rate has not increased, rather dropped to 0.147% today from 0.151% on 27 June. Given that the ECB Governing Council meeting is on 5 July, it is quite possible that the market is anticipating a rate cut by then. Still, the large increase in just two days time might represent elevated stress and fear of no real solution in the Euro summit.

EONIA Swap rates seem to be pointing to an upcoming ECB rate cut, with short-term rates (up to 1 month) falling sharply (although longer tenors are increasing somewhat which is a bit puzzling, unless the market believes that conditions will stabilize within the next months):

Update 29/6: The overnight Eurepo rate dropped significantly after the Euro summit to 0.153% on Friday, as well as longer tenors. It looks like the spike was mainly due to a bearish view of the summit outcome. Eonia swap rates increased a bit on Friday which in my view points to a stabilization of the money market within the next month. Based on the current Eurepo rates, i think that a rate cut from the ECB on Thursday is a real possibility.

Update 2/7: Here’s a calculation of monthly standard deviations of the overnight rate during 2012. It is clear that the ECB liquidity injection (through 3Y-LTROs) lowered Euepo SD considerably down to 0.373 in the first half of June. Since 14 June, both the rate average and SD have increased significantly, above March levels. Such a behavior should reflect market stress.

Based on ECB data the following table combines daily repo rates with recource to the marginal lending facility. There’s a clear pattern of increased marginal lending during periods of higher repo rates:

Update 4/7: Euro MTS data is available for the Italian repo market and it can be used to examine actual, per security, repo rates/volume movements. I ‘ve created a pdf (EuroMTS-Italy) with data for 28 and 29 June. It is clear that rates for some instruments were more than double between the two trade dates, which point mainly to market problems.