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

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