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As I ‘ve highlighted many times in the past, the level of future long-run primary surpluses for Greece plays a major role in the debt sustainability scenarios. The major difference between the IMF and Euro institutions projections is identified in the primary surplus assumptions. The IMF projection for a 1.5% surplus makes debt restructuring necessary while the European institutions assume much higher primary balances which make debt sustainability more favourable.

IMF vs Euro Institutions Greek DSA

A recent ESM paper on Greek debt reveals the importance of these projections. If Greece achieves 3.5% primary surplus until 2032 and 3% until 2038 no debt restructuring is required as long as economic growth is 1.3%. On the other hand, the IMF scenario of 1% economic growth and a primary surplus of 1.5% after 2022 makes Greek debt explosive.

European institutions try to make the case that episodes of large and sustained primary surpluses are not uncommon in European modern history. The ECB especially highlights the cases of Finland and Denmark as well as other countries:

The European Central Bank says such long periods of high surplus are not unprecedented: Finland, for example, had a primary surplus of 5.7 percent over 11 years in 1998-2008 and Denmark 5.3 percent over 26 years in 1983-2008.

and

ECB - Selected Episodes of large and sustained primary surpluses in Europe

My comments are twofold. First, the average primary surplus figure is not always equal to the year-by-year primary balance. Denmark achieved a primary surplus equal or higher than 5.3% in only 5 years during the 1983 – 2008 period. Actually, the primary surplus was at least 3.5% during 9 of the total of 26 years.

Yet the most important element that is not highlighted in the above cases is the fact that large primary surpluses were achieved in the context of equal or (mostly) higher current account surpluses. This is highly important since it allows the domestic private sector to achieve a positive net asset position even when the public sector is in surplus. As a result, economic growth is not threatened by the public sector and the private sector maintains a healthy balance sheet.

To illustrate the above I ‘ve «corrected» the primary surplus by subtracting the current account surplus. I ‘ve also deliberately set the vertical axis maximum to 3.5% which is the surplus requested from Greece to illustrate the fact that it is almost never achieved.

corrected primary balance for current account - selected high surplus episodes.jpg

On the contrary, of the total of 60 years in the above episodes, 26 had a negative corrected primary surplus while it was lower than 1.5% in 40 years illustrating the fact that the IMF assumption of a 1.5% surplus is not unreasonable.

Since the Greek cyclically adjusted current account is highly negative it is clear that the assumption of high primary surpluses which will be maintained for decades is almost without precedence in the context of the private sector balance. Assuming a 3% nominal growth rate (based on the IMF assumption of 1% growth), a 10 year 3.5% primary surplus is equal to a 30% GDP transfer from the domestic private sector while a 20 year 3.5% surplus is equal to 52% GDP transfer which will not be counterweighted by a current account surplus.

In my view, the European institutions continue to make assumptions consistent with avoiding explicit costs for Greece’s creditors but inconsistent with economic reality and sectoral balances.

Since the second 3Y LTRO matured this week while the ECB QE starts in a few days it is interesting to take a quick look at the overall liquidity position of the European banking system. According to the latest Eurosystem weekly statement, lending through regular refinancing operations (MRO and LTROs) was €501.3bn during the preceding week (this does not include the sizable ELA lending of Greek banks which appears to have increased by €5.6bn).

Based on the outstanding OMOs, total lending now stands at €488,3bn. A large part of the maturing 3Y LTRO was replaced by higher MRO lending (which increased to €165.35bn from €122.11bn in the previous week) yet overall financing was €13bn lower and now stands at less than €500bn. In other words, total bank financing is now close to the allotted amounts of each of the two 3Y LTROs (first: €489.2bn, second: €529.5bn).

Obviously the European banking system has lowered its reliance on Eurosystem financing substantially. It seems that any increase in the Eurosystem balance sheet will only be the product of outright purchases through the ABSPP/CBPP3 and government bond program. It is even probable that individual banks will use the newly created reserves in order to reduce their reliance on Eurosystem financing and free encumbered collateral which will result in lower MRO allotments in the next few weeks. Consequently, one should observe almost immediate effects on repo market rates and turnover by the upcoming ECB QE purchases.

Since I recently submitted my MSc in Finance dissertation titled «The informational content of SMP deposit auctions in forecasting short-term repurchase agreement interest rates», I would like to take the opportunity to write a few words on its conclusions. The main objective of the research was to examine whether SMP deposit auctions carried valuable information for forecasting short-term repo rates. Since banks with excess liquidity always faced the choice between parking their reserves at the weekly term-deposits for a week or lending them in the GC repo market, SMP deposit rates should act as an effective floor on risk-free money market rates.

In order to evaluate the above hypothesis the paper first suggested a stochastic model for the bid rate in auctions (based mainly on the level of excess reserves in the system) as well as the conditional variance of the bid rate process (the calculation suggested that the variance was not steady but a function of excess reserves therefore implying that a possible econometric specification would face heteroskedasticity problems).

The econometric specification used a cointegrating relationship between the weekly GC and SMP deposits rate in a VEC model also containing excess bids, number of bids and the VIX index (as a proxy of market stress) as explanatory variables. A competing VAR model of the MRO and GC rate was estimated and out of sample forecasts of the GC rate for the two models were compared. The results clearly indicated that the SMP deposits did provide significant informational content for short-term money market rates.

A few people might find the (very) large section in monetary policy and repo market details informative and helpful. Overall the paper is quite technical but I hope relevant for evaluating the effectiveness of certain sterilization tools used by central banks in recent years. It might prove useful in analyzing related facilities used by the Federal Reserve (such as Interest on Reserves and the overnight and term reverse repo facilities), a topic that interests myself as well.

So it seems that a European QE program is highly probable although Greek government debt is at risk of not being included since it is not rated investment grade and the ECB will only include it in the list of assets purchased if Greece remains in a refinancing program.

In this short post I ‘d like to note a few things on the magnitude of the impact that such a program would have on Greek bonds. Based on the Greek ECB capital key (2%) and the anticipated QE size (which most analysts put around €500bn), the ECB might end up buying around €10bn of Greek debt securities. PSI related bonds principal is now around €29.6bn while long-term bonds issued by the Greek government during 2014 totaled another €6.9bn. Bonds with a residual maturity of up to 10 years are only €12,2bn which, given current market prices, are worth much less than €10bn.

Greek bonds till 2029

As a result, ECB will ultimately be making a bid for all the outstanding market value of long-term Greek bonds (with a residual maturity of up to 10 years), increasing liquidity in the bond market considerably (and making it the largest holder of Greek debt). That will obviously drive current market prices much higher and also allow the Greek government to immediately return to the market since bidders will have a (free) put option of selling most of their holdings to the ECB. As long as the upcoming QE is pari passu with private bondholders (as is the OMT program) and the Greek government establishes a credit line program (which creates another put option for bondholders) the (QE) program will allow an orderly return of the Greek government to private bond markets.

Since the Greek debt maturity profile suggests that only mostly 2015 and 2019 are years that involve large debt refinancing needs (which lowers any default risk post 2015) a QE program will have long-lasting stabilization effects. These effects will be even higher if ECB profits from the program are returned to the corresponding Treasuries (which I suspect will happen if eventually the program involves each NCB buying its own government debt securities).

nov14 Greek debt maturity profile en

Personally I would also like to see a second buyback of Greek debt to take advantage of low market prices and also to lower the nominal value of post-PSI bonds which, due to the EFSF co-financing scheme, are senior to newer bonds issued by the Greek government (a fact that can create difficulties for Greece issuing bonds that have similar maturity dates as outstanding PSI bonds). A possible buyback could be combined with an exchange offer to consolidate the current series (which stretch a 20 year period with low nominal values per bond of less than €1.5bn) into two or three securities that will be of much larger nominal value and liquidity and thus improve market making and secondary market trading.

Given the recent substantial increase in Greek political risk and the high probability of early elections I ‘d like to comment on a recurring theory that ECB can threaten to close down Greek banks access to liquidity (in the same manner it did in Cyprus) in case that a newly elected Syriza government does not adhere to the currently agreed upon measures, reforms and budget cuts.

In my view, 2015 is quite different than 2012 and the possible threats that the ECB could (then) make against Greece are no longer possible.

The main measure that the ECB can take against Greece in case that the current program is put on hold is to remove the waiver on accepting Greek government guaranteed securities and other assets as collateral in its regular refinancing operations. The important fact to keep in mind though is that Greek banks do not hold significant amounts of Greek government bonds on their balance sheets any more. They only have a little over €10bn of relevant securities of which almost €5bn are Treasury Bills. The collateral being used in ECB operations are mainly the EFSF notes that banks acquired from the Hellenic Financial Stability Fund (HFSF) when they were recapitalized after the PSI. The nominal value of these notes exceeds €37bn which coupled with other assets (such as credit claims) covers current ECB financing which stands close to €45bn.

Any additional financing requirements can be covered through ELA financing although this will necessarily result into much higher borrowing costs (since the ELA rate is more than 150bps higher than the ECB marginal lending rate). The threat of closing down ELA (as in Cyprus during 2013) is only possible if the Greek banks do not cover minimum capital requirements. Given that it’s only been a few weeks since the ECB stress test results were announced during which the central bank affirmed the strong capital position of Greek banking institutions it is not at all clear how the ECB would be able to justify not allowing or placing hard limits on ELA financing.

Moreover, even if negotiations between Greece and its creditors go south this cannot have any effect on the EFSF notes held by banks since any principal and interest payments on EFSF loans will be made after 2020 (interest payments have been deferred and capitalized until at least 2022). Coupon payments on PSI bonds (including bonds issued during 2014) stand around €1bn per year and do not create substantial problems. Unfortunately the EFSF loan does contain cross default clauses referring to the rest of Greek obligations so a future Greek government should proceed with caution although the Greek law covering ECB SMP bonds does provide some room to maneuver* .

Greek debt payments during 2015 mainly involve T-Bill rollovers and payments of €7bn towards the ECB (for SMP bonds) and €9bn towards the IMF:

Greek Bonds T-Bills 2015

ECB’s main leverage over Greece concerns whether liquidity will be provided through regular OMOs or ELA and if Greek bonds will be included in a possible future QE program. The latter will obviously allow a much more orderly access to capital markets for bond issuance, especially coupled with the presence of an EFSF ECCL program.

* When I first wrote the post I had in mind that ECB Greek bonds are covered by Greek law. It turns that the ‘default events’ on the EFSF financing agreement cover more or less all of Greek government liabilities.

ECB’s Targeted LTRO is now a reality. What I would like to examine in this short post is the fact that actual net liquidity injection will not be equal to the TLTRO’s allotment as most people would think but the net result of various liquidity providing operations and LTRO repayments. More specifically, net liquidity will be the sum of:

  1. TLTRO allotment (€82.6bn)
  2. Repayments of earlier 3Y-LTROs which increased substantially after the TLTRO auction (a total of €19.9bn)
  3. Changes in MROs
  4. Changes in maturing (3-month) LTRO rollovers.

Adding today’s 3m-LTRO rollover the data are as follows:

TLTRO net liquidity

Overall, ECB’s first TLTRO managed to inject a total of €48bn of net liquidity. Given the stated target of increasing the ECB balance sheet by close to €1tr it is clear that the operation was a drop in the ocean. European banks most probably used a large chunk of the TLTRO funds in order to replace 3Y-LTRO funding (the corresponding operations mature in a few months time) and MRO liquidity (replace short-term funding at a variable rate with stable long-term funding at a constant rate only 10bp higher than the current MRO rate) rather than to immediately expand their reserve position. Given that the remaining liquidity due to the 2 3Y-LTRO is still well over €300bn and will be maturing in a few months time it seems that a large part of the TLTROs will go in rolling over these reserves instead of creating additional excess liquidity.

In this short post I would like to emphasize the important role of the ECB (conditional) commitment for Outright Monetary Operations (OMT) in reducing tail risks and credit spreads in the Euro periphery bond markets. In order to do that I will analyze OMT in terms of option pricing and insurance.

The role and details of OMT are quite well known by now. The main factors that made the commitment so successful (without even having to implement them) were:

  1. The OMT portfolio will be pari passu with private bondholders. As a result, bonds purchases by the ECB do not create a senior debt-holder (as was the case for the SMP portfolio) while remittance of Eurosystem profits due to these operations allows troubled debt countries to effectively earn seignorage income and lower their debt servicing costs.
  2. Operations are conditional on an official bailout (which is usually accompanied by strict conditionality). Since bailouts tend to favor creditors at the expense of domestic citizens (with austerity measures targeting essential government services and private sector wages but usually not capital income and gains) they lower the risk of debt restructuring in the sense of making it much more difficult for the debtor country to prioritize its own citizens welfare. Furthermore, by having the ECB buy a large part of the country’s debt, private bondholders are not subordinated in the same way as a pure ESM bailout.
  3. The fact that the ECB will probably remit its OMT profits back to the debtor country plus the low interest rates in ESM loans (in contrast with the initial high rates of the Greek Loan Facility) mean that a large part of a country’s deficit reduction will come from interest expenses and not from savings in expenses or higher taxes with a much milder result on economic growth (and a positive impact on long-run debt sustainability).

Still a lot of people find it odd that OMT was able to lower spreads by such a large amount without any operations actually taking place in the bond markets. One has to realize that by committing to OMT, the ECB is essentially setting a ceiling on the spread of government bonds (although a bit vague) since any large increase in credit spreads will lead a country to ask for a bailout and an activation of OMT. As a result, a private bond holder is guaranteed that the price of her bonds will not fall lower than a specific floor, since in that case, she will have the option of ‘selling’ them to the ECB. In other words, the ECB is writing a set of ‘free’ put options on Eurozone debt, standing ready to buy bonds at current market prices after the relevant country has requested a bailout.

In order to look into the issue from a more technical angle, lets assume that the bond hazard rate (probability of default in a period conditional on survival until that period) follows an Ito process similar to the CIR process of interest rates (see Filipovic, chapter 13):

hazard processwhere W is a Wiener process. Given this process one can calculate the default probability which (although quite technical) obviously depends on the drift parameters (b,β) but more importantly on the volatility as well. As a result, if volatility is modeled in an autoregressive model such as GARCH(1,1), periods of high bond price volatility quickly lead to higher estimates of default probabilities. Since the default probability can be considered as the Ν(-d2) term of a credit risk put option (with a strike price equal to the expectation of the recovery rate), the model estimated probability can be used for option pricing and bond portfolio insurance.

By insurance I am referring to the policy of creating a synthetic put option (by shorting bonds) in order to insure a bond portfolio from downside risks.This has the advantage that the bond holder does not have to keep a matched book bond position but only short the proportion (determined by the default probability) of the portfolio needed to hedge against the tail risk of default (assuming of course that interest risks have already been hedged through an IRS for instance) while earning all upside gains. An increase in the default probability increases the proportion necessary to hedge the downside risk, a strategy that can create self-fulfilling issues since the bondholders sell when bond prices fall and might face difficulties in borrowing bonds (to short) through reverse repos.

By introducing OMT, the ECB becomes the writer of the above option (something very similar to a CDS) and removes the need for active hedging. This immediately reduces bond volatility (since bondholders do not need to increase their short positions) while a high σ actually makes the option more valuable and pushes bond prices higher. Periods of high volatility (such as the summer of 2012) are immediately followed by a drop in volatility under efficient markets. As long as the ECB commitment is not questioned, Euro bond prices include this put option and permanently increase in price by market forces without a need for any actual ECB operations.

Obviously, the stability of the ECB determination to implement unlimited bond purchases will play a decisive role in the future (given the recent German Constitutional Court case for instance) yet it is clear that at this point, OMT has played a decisive role in minimizing Eurozone tail risks and lowering Euro periphery countries debt costs.

The SNB released data on its FX reserves regarding 2012Q3. Securities investments were CHF342.73bn while deposits 86.58bn in September. Here’s a breakdown for the last few months:

* Sources: [1], [2]

It is clear that the SNB managed to increase its reserves substantially while actually decreasing its deposits with foreign central banks (mainly the ECB). In Euro terms FX reserves increased €53.6bn, securities €71.1bn and deposits dropped €17.5bn. As a result, the growth in its reserves was not reflected on the Eurosystem balance sheet as during 2012H1.

Data on investment assets composition were also released:

 

What’s clearly impressive is the fact that the SNB was able to diversify out of the Euro and into other currencies such as the US$ and the BGP with Euro share dropping from 60% to 48%. Government bonds also dropped a bit from 85% to 83%. Calculated euro securities holdings went from €154bn in 2012Q2 to €164bn in 2012Q3, a change of only €10bn, despite securities increasing by over €71bn during the same period. In other words (assuming that all of SNB FX reserves are a result of its Euro floor), around €60bn were sold in exchange for other currencies in 2012Q3 which should be considered a large flow.

It will be very interesting to observe how the SNB reserves balances change in September.

SNB released data on its FX reserves for June 2012. They ‘ve grown from CHF305.9bn to 364.9bn, an increase of  59bn or around €49.2bn. ECB’s liabilities to non euro area residents increased by €33.5bn from €116.4bn to €149.9bn during the same period. So it seems that euro outflows kept their strength in June. The difference between SNB and ECB figures probably suggests that the SNB invested a part of its reserves in securites (although FX reserves data also include other currencies and their exact composition is not known for June).

ECB released its weekly statement for the week ending at 8 June 2012.

Based on an increase in the MRO last week (and the fact that ECB data pointed to an increase in net autonomous factors) i anticipated that ECB’s liabilities would increase by roughly the same amount. It turns out that the increase was ELA repayment after all, with the latter decreasing by€ 61bn (a very large amount). Lending from the ECB increased by €69.5bn, mostly through the MRO (€68.2bn increase), although the marginal lending facility also increased by €1.2bn.

On the liability side, the important observation is the continued increase in ‘Liabilities to non-euro area residents denominated in euro’ which grew by €13.2bn and is most probably attributed to SNB foreign reserves accumulation. The inflow into swiss assets is quite evident in the negative yield swiss bond curve:

Apart from the weekly statement, an MRO and LTRO was also conducted today. Compared to the previous MRO, this week’s operation increased by €12.4bn (€131.8bn vs €119.4bn) while the 1 month LTRO grew  by €5.9bn (€18.9bn from €13bn), a total increase of roughly €18.3bn which is surely a large amount.