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Lately, there’s (finally) some talk about a Large Scale Asset Purchase (LSAP) program from the ECB. I ‘d like to elaborate a bit on the implementation of such a program since the Eurosystem structure and the segmented government debt market pose certain issues.
Usually, LSAPs are used mainly to steer long-term interest rates and provide monetary stimulus to the economy by making financing of durable goods purchases and long-term investment (like housing) more affordable. In the Euro case though, the main problem is the disfunctioning monetary transmission mechanism with certain government securities not being perfect substitutes with bank reserves. This is evident if one compares yields with corresponding Overnight Index Swaps:
Since there’s still excess liquidity in the Euro banking system, EONIA mostly arbitrages with the ECB deposit rate rather than the MRO rate (since banks with excess liquidity are not the ones borrowing excess funds). As a result, short-term government paper should be mostly considered as the equivelant of a fixed-term deposit at the ECB, making them close substitutes with bank reserves.
It is clear from the above table that core countries securities actually carry a premium (compared to unsecured interbank lending swaps) up to 1 year and arbitrage quite closely for longer maturities. On the other hand, Italian and Spanish paper carry considerable risk and are ideal targets for LSAP. Any GDP-weighted LSAP would waste a large part of resources without having any real ecnomic impact (since they would be a perfect asset swap, replacing assets with roughly the same ‘economic value’).
An important issue with LSAPs is which NCB will actually perform the purchases. As long as non-issuer country NCBs buy securities, any coupon payments will register as an increase in Target2 liabilities (for the issuer country) and contribute to the Eurosystem profits (minus the fixed-term deposit rate used to sterilize any purchases). Unless monetary profits are remmited back to the issuer Treasury, they will be removing domestic interest income and not contribute to any reduction in the current account income deficit of the issuer.
Taking an accounting view, LSAP will remove an interest bearing asset from bank balance sheets and replace it with bank reserves which currently pay close to zero (zero for the deposit facility and close to zero for the fixed-term deposits). The most probable impact will be a reduction in net lending from the ECB by the banks selling the assets, although the speed will depend on if their loans are short-term (MROs) or long-term (LTROs). The net income impact would probably still be negative while it would allow for collateral to be removed from ECB borrowing and made available in private money markets. Any capital gains would provide immediate income for sellers and lower collateral needs of banks borrowing from the ECB and using government paper as collateral (due to positive effects from daily mark-to-market). As a result, a LSAP announcement would probably be followed by excess liquidity banks trying to front-load the ECB.
Since the ECB uses weekly-term deposits to sterilize the impacts of any asset purchases, the net effect would be a reduction in liquidity available for private money markets and a probable push of interbank rates closer to the MRO rate. This means that any LSAP would be accompanied by a reduction of the MRO rate to lower levels such as 0.5% in order to avoid a defacto monetary tighting stance.
Overall, LSAP can be positive but can have several unintended consequences.
The ECB finally released the details of the new bond buying program called Outright Monetary Operations. One of the things that made me wonder is the following: The ECB justified the new program on the grounds that convertibility risk does not allow the monetary transmission mechanism to work properly with periphery interest rates being much higher than the core and not reacting to ECB rate cuts. Nevertheless, the program will be activated for countries that request EFSF/ESM assistance and will only be used to assist current program countries to regain market access in the future. It sounds really strange to stress an urgent and real problem and use it to announce a program that will only be implemented in the future, under strict conditionality without addressing the current actual problem of high interest rates (evident especially in Greece and Portugal).
The fact that the SMP will remain senior while OMT will be pari passu to private holders is quite puzzling, especially since both are considered monetary instruments. As another commentator has stated, the ECB is not a preferred creditor (it only buys bonds in the secondary market) but a ‘preferred investor’. My feeling is that the ECB will eventually avoid participating in any other future debt restructures.
I ‘ve already stated my view on how to make ECB purchases more effective. The ECB should pledge to immediately remit any monetary profits (due to discounts and interest payments) to the issuing country, roll over its holdings (for as long as it considers the monetary mechanism not working properly) and issue ECB marketable debt certificates in order to sterilize its holdings instead of term deposits.
The OMT has definitely bought some more time to Euopean countries. Still, strict conditionality will only work to push periphery countries further into recession and eventually hurt debt sustainability by reducing GDP. On the other hand, the monetary union mechanisms do allow for large capital movements without threatening the survival of the Euro project while placing a cap on interest payment deficit (since Target2 liabilities only pay the ECB MRO rate). ECB bond buying and ESM/EFSF assistance are necessary parts of these mechanisms.
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:
- 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).
- 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:
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