Satyajit Das: There is a misplaced reliance on the European Central Bank

 

Voters in Greece and France have voted against austerity. Voters elsewhere in Europe will probably follow suit in time. Despite summits and communiqués, politicians and policy makers cannot miraculously create growth overnight. The only likely action in the short run will probably come from the European Central Bank (“ECB”).

As the real economy stalls and debt problems continue, interest rate may be cut to near zero. Money can be made available to recapitalise banks, especially to Spain to defer the need for a full bailout of the country. A Europe wide deposit guarantee scheme underwritten by the ECB to reduce the risk of capital flight may be implemented.

Further liquidity support, perhaps even full-scale quantitative easing, cannot be ruled out. In December 2011 and February 2012, the ECB via the LTRO (“Long Term Refinancing Operation”) offered unlimited financing to European banks at 1% for 3 years. Banks drew over Euro 1 trillion under the facility.

The funds borrowed were used to purchase government bonds, retire or repay existing more expensive borrowings and surplus funds were redeposited with the ECB. The LTRO provided finance for both beleaguered sovereigns and banks, which need to raise around Euro 1.9 trillion in 2012. It helped reduce interest rates for countries like Spain and Italy. It also helped banks covertly build-up capital, via the profits earned through the spread between the cost of ECB borrowings (1%) and the return available on sovereign bonds (5-6%).

But the ECB cannot resolve the crisis through its actions. For example, the LTRO facility is for 3 years. It assumes that the conditions will normalise within that period. The ECB is now functioning as a financial institution, assuming significant credit and interest rate risks on its loans.

The ECB measure do not address fundamental issues.

They do not reduce the level of debt in problem countries, merely finances them in the short-run. Europe was relying on its austerity program to reduce debt. As Greece demonstrated and Ireland, Portugal, Spain and Italy are demonstrating, massive fiscal tightening when combined with private sector reduction in debt merely puts the economy into recession. It results in an increase not decrease in public debt.

Debt restructuring is needed to achieve the required reduction in the public borrowings for many countries. Financial markets price the risk of a Spanish debt restructuring at around 30-35%.

ECB policies like the LTRO do not improve the cost or availability of funding for the relevant countries. Government bond purchases financed by the ECB artificially decreased the interest rates for countries, such as Spain and Italy. But interest rates have returned to market levels.

The real increase in liquidity available to support sovereign borrowings was lower than Euro 1 trillion, with perhaps only 10-30% directed to this purpose. Banks used the bulk of funds to repay their own borrowings. As debt becomes due for repayment through the year, banks may need to sell sovereign bonds purchased with the funds drawn under the LTRO.

The need for collateral to support ECB funding makes other investors de facto subordinated lenders reducing their willingness to lend or increasing the cost. In the Greek restructuring, European Central Banks and official institutions were exempted by retrospective legislation from loss while other investors suffered 75% writedowns. This has reduced investor willingness to finance countries considered troubled.

European banks already have large exposures to sovereign debt, which the ECB actions have encouraged them to increase. Italian banks now hold nearly Euro 324 billion-worth of sovereign bonds. The Spanish banking sector holds Euro 263 billion. Spanish and Italian banks are thought to have purchased around Euro 90 billion and Euro 50 billion of their country’s bonds since the commencement of LTRO. As interest rates on Spanish and Italian bonds have increased, buyers now have large unrealised mark-to-market losses on these holdings.

As with the sovereigns, the ECB cannot solve the longer term problems of the solvency or funding of the banks. Increased reliance by Spanish and Italian banks on financing from central banks is a concern. Spanish bank borrowings from the ECB increased to over Euro 300 billion in March from Euro 170 billion in February. Lending to Spanish banks now accounts for nearly 30% of total ECB lending. Italian banks have also been heavy borrowers, a reminder of the linkage between banks and their sovereigns.

The ECB’s actions have not materially increased the supply of credit to individual and businesses.

Fundamental problems – debt levels, trade imbalances, asset quality of the banking sectors, required structural reforms, employment and economic growth – remain.

The inability of the ECB’s actions to decisively reverse the crisis should not be a surprise. Confidential analyses prepared by European Union officials and distributed to ministers meeting at the Copenhagen meeting in March 2012 concluded that the Euro 1 trillion in loans was a “reprieve”, rather than a solution.

Europeans want a quick return to a period Spaniards now refer to as cuando pensábamos que éramos ricos which translates into “when we thought we were rich”. Unfortunately, there is no simple, painless way in which this can be achieved.

Satyajit Das is author of Extreme Money: The Masters of the Universe and the Cult of Risk

Start your day with The Independent, sign up for daily news emails
ebooks
ebooksAn introduction to the ground rules of British democracy
Latest stories from i100
Have you tried new the Independent Digital Edition apps?
SPONSORED FEATURES
Independent Dating
and  

By clicking 'Search' you
are agreeing to our
Terms of Use.

iJobs Job Widget
iJobs Money & Business

Recruitment Genius: Field Sales Consultant - Financial Services - OTE £65,000

£15000 - £65000 per annum: Recruitment Genius: This is an exciting opportunity...

Recruitment Genius: Loan Underwriter

£18000 - £20000 per annum: Recruitment Genius: This is a fantastic opportunity...

Recruitment Genius: Collections Agent

£18000 - £20000 per annum: Recruitment Genius: This is a fantastic opportunity...

SThree: Trainee Recruitment Consultant

£20000 - £25000 per annum + competitive + incentives + uncapped comms: SThree:...

Day In a Page

The Silk Roads that trace civilisation: Long before the West rose to power, Asian pathways were connecting peoples and places

The Silk Roads that trace civilisation

Long before the West rose to power, Asian pathways were connecting peoples and places
House of Lords: Outcry as donors, fixers and MPs caught up in expenses scandal are ennobled

The honours that shame Britain

Outcry as donors, fixers and MPs caught up in expenses scandal are ennobled
When it comes to street harassment, we need to talk about race

'When it comes to street harassment, we need to talk about race'

Why are black men living the stereotypes and why are we letting them get away with it?
International Tap Festival: Forget Fred Astaire and Ginger Rogers - this dancing is improvised, spontaneous and rhythmic

International Tap Festival comes to the UK

Forget Fred Astaire and Ginger Rogers - this dancing is improvised, spontaneous and rhythmic
War with Isis: Is Turkey's buffer zone in Syria a matter of self-defence – or just anti-Kurd?

Turkey's buffer zone in Syria: self-defence – or just anti-Kurd?

Ankara accused of exacerbating racial division by allowing Turkmen minority to cross the border
Doris Lessing: Acclaimed novelist was kept under MI5 observation for 18 years, newly released papers show

'A subversive brothel keeper and Communist'

Acclaimed novelist Doris Lessing was kept under MI5 observation for 18 years, newly released papers show
Big Blue Live: BBC's Springwatch offshoot swaps back gardens for California's Monterey Bay

BBC heads to the Californian coast

The Big Blue Live crew is preparing for the first of three episodes on Sunday night, filming from boats, planes and an aquarium studio
Austin Bidwell: The Victorian fraudster who shook the Bank of England with the most daring forgery the world had known

Victorian fraudster who shook the Bank of England

Conman Austin Bidwell. was a heartless cad who carried out the most daring forgery the world had known
Car hacking scandal: Security designed to stop thieves hot-wiring almost every modern motor has been cracked

Car hacking scandal

Security designed to stop thieves hot-wiring almost every modern motor has been cracked
10 best placemats

Take your seat: 10 best placemats

Protect your table and dine in style with a bold new accessory
Ashes 2015: Alastair Cook not the only one to be caught in The Oval mindwarp

Cook not the only one to be caught in The Oval mindwarp

Aussie skipper Michael Clarke was lured into believing that what we witnessed at Edgbaston and Trent Bridge would continue in London, says Kevin Garside
Can Rafael Benitez get the best out of Gareth Bale at Real Madrid?

Can Benitez get the best out of Bale?

Back at the club he watched as a boy, the pressure is on Benitez to find a winning blend from Real's multiple talents. As La Liga begins, Pete Jenson asks if it will be enough to stop Barcelona
Athletics World Championships 2015: Beijing witnesses new stage in the Jessica Ennis-Hill and Katarina Johnson-Thompson heptathlon rivalry

Beijing witnesses new stage in the Jess and Kat rivalry

The last time the two British heptathletes competed, Ennis-Hill was on the way to Olympic gold and Johnson-Thompson was just a promising teenager. But a lot has happened in the following three years
Jeremy Corbyn: Joining a shrewd operator desperate for power as he visits the North East

Jeremy Corbyn interview: A shrewd operator desperate for power

His radical anti-austerity agenda has caught the imagination of the left and politically disaffected and set a staid Labour leadership election alight
Isis executes Palmyra antiquities chief: Defender of ancient city's past was killed for protecting its future

Isis executes Palmyra antiquities chief

Robert Fisk on the defender of the ancient city's past who was killed for protecting its future