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BdE published the balance of payments for September 2012 (and 2012Q3). Developments are quite positive. Regarding the current account:

Spain current account sep 2012


The goods balance is now firmly below the -€3bn/month threshold. Compared to -€31bn in the Jan – Sep 2011 period, the balance was -€22,13bn. It’s quite positive that most of the improvement is attributed to larger goods exports (+€5.7bn to €170.52bn) than lower imports (-€3.2bn to €192.65bn). The balance in services was also improved by €3.45bn. Total goods and services balance is now +8.17bn compared to -4.15bn a year ago.

A very large improvement came from the income balance which registered at -€16.61bn, down €2.7bn from last year. After growing to more than -€3.1bn during July, the balance dropped below -€1bn during August and September most probably driven by the ‘ECB effect’.

Current transfers were -€8.07bn compared to -€6.84bn in J-S 2011 and the capital account was €3.92bn after €4.17bn a year ago. Overall, the current+capital account deficit is now mainly driven by the income deficit.

Spain financial account sep 2012


The financial account was also quite positive during September. Portfolio investment turned strongly positive during September (+€9.75bn after a +€2.34bn in August and -€10.82bn in July), a strong display of ECB ‘powers of persuasion’. Large inflows were registered in the general government category while ‘other sectors’ also had a positive balance after a long time (+€3.34bn after -€2.78bn in August) and MFI outflows continued dropping with September reading below -€2bn.

The largest change was in the other investment balance where investment on MFIs went from -€21.52bn during August to €4.93bn in September, marking the return of Spanish banks in the Euro interbank market.

External adjustment is definitely making progress in the case of Spain (with exports showing healthy increase) while ECB actions allowed for a complete U-turn on capital outflows. How long the ECB effect will last is an open question.

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.

In recent days, the ECB has started to pay closer attention to the fact that the monetary transmission mechanism of its interest rate policy is quite broken in the case of the periphery, making its rate cuts ineffective. The problem stems from the fact that both its own financing operations as well as general interbank lending is done through the repo market (in the case of the interbank market there is also the unsecured market although that is shrinking, especially for periphery banks). As a result, volatility in collateral values (either that posted on ECB operations or in private repo loans) plays a major factor in the effective repo rate (after margin calls are covered). Moreover, high volatility collateral leads to higher haircuts (so that the lender is safe from a large price move in case he had to liquidate his collateral) while periphery counterparty risk (undercapitalized banks with large NPLs and risky assets) leads to higher general repo rates.

Another factor is the large Target2 liabilities which are financed by central bank lending and increase the effective ‘liabilities cost’ of banks.

In such a context, rates will not be transmitted efficiently in the case of banking systems with high volatility collateral. The obvious solution is to lower volatility which can happen in two ways:

  1. Use credit claims as collateral which do not face daily mark-to-market although they are subject to large initial haircuts (making the effective loan capacity lower). The LTROs used such a framework by relaxing collateral rules on eligible credit claims (and also accepting government guaranteed bank private bonds).
  2. Lower the volatility of securities used as collateral which requires a buyer of last resort (a role that was played by the SMP portfolio and might be taken over by the EFSF/ESM).

Based on the above one can reasonably assume that further rate cuts by the ECB are not in the agenda until the transmission mechanism is fixed. That would necessarily involve some combination of relaxed collateral rules and a secondary market securities purchase mechanism (SMP or EFSF/ESM). The open question is if such a move would be enough to lower counterparty risk and increase private repo turnover/lower euro outflows from the periphery or if it will lead to the ECB being an even larger market maker.

For now interest rates on new loans (up to €1mn) to non financial corporations with maturity higher than 5 years are quite different in the periphery compared to Germany, although they should include significant local macro risk in the case of the periphery:

During the last few days, eurepo rates have been increasing, especially in very short-term maturities:

* source

In my view this increase can be attributed to:

  • Lower excess liquidity in periphery banks (especially Spanish/Italian ones) which pushes them to higher use of MRO lending (as is evident in recent ECB weekly statements). Since the MRO rate is paid on the operation maturity (MROs are weekly operations), the banks cost of funds is higher (compared to the LTROs) which pushes their offered repo rates to higher levels.
  • Capital flight from the Eurozone as a whole which mostly moves to Swiss banks. The latter could probably have tighter lending standards and require higher compensation for their borrowing in the euro repo market. Furthermore, any euros acquired by the SNB (as part of its swiss franc floor policy) will probably be parked at the ECB (or maybe invested in German debt) and not lent in the interbank market.
  • General risk avoidance (especially given the ongoing rating downgrades of European banks) with a shortening of repo maturities and higher repo rates (to compensate for higher risks).

Luckily, the EBF also provides detailed daily rates per panel bank which seem to confirm the above hypothesis:

The increased rates from ING are a bit worrying. It’s also quite evident (especially if one looks at the total panel bank data) that there’s a visible increase in both the ‘risk-free lending rate’ (which is probable around 0.15%) as well in the troubled bank premium (which offer rates close to 0.20%).

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Kostas Kalevras

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