Who went back and read Mario Draghi’s full, market-moving remarks in London on Thursday — beyond the “whatever it takes” and “yields” bits?
It’s a far more subtle read than Friday’s headlines tell you — detailed without being technocratic, ranging candidly across the unintended consequences of regulation of banks’ liquid assets, to ‘de-euroisation’, and national bias in financial supervision.
The ending, on bond risk premia and “our remit”, also contains a surprise:
There are some short-term challenges, to say the least. The short-term challenges in our view relate mostly to the financial fragmentation that has taken place in the euro area. Investors retreated within their national boundaries. The interbank market is not functioning. It is only functioning very little within each country by the way, but it is certainly not functioning across countries…
And I think the key strategy point here is that if we want to get out of this crisis, we have to repair this financial fragmentation.
There are at least two dimensions to this. The interbank market is not functioning, because for any bank in the world the current liquidity regulations make – to lend to other banks or borrow from other banks – a money losing proposition. So the first reason is that regulation has to be recalibrated completely.
The second point is in a sense a collective action problem: because national supervisors, looking at the crisis, have asked their banks, the banks under their supervision, to withdraw their activities within national boundaries. And they ring fenced liquidity positions so liquidity can’t flow, even across the same holding group because the financial sector supervisors are saying “no”.
So even though each one of them may be right, collectively they have been wrong. And this situation will have to be overcome of course.
And then there is a risk aversion factor. Risk aversion has to do with counterparty risk. Now to the extent that I think my counterparty is going to default, I am not going to lend to this counterparty. But it can be because it is short of funding. And I think we took care of that with the two big LTROs where we injected half a trillion of net liquidity into the euro area banks. We took care of that.
Then you have the counterparty recess related to the perception that my counterparty can fail because of lack of capital. We can do little about that.
Then there’s another dimension to this that has to do with the premia that are being charged on sovereign states borrowings. These premia have to [do], as I said, with default, with liquidity, but they also have to do more and more with convertibility, with the risk of convertibility. Now to the extent that these premia do not have to do with factors inherent to my counterparty – they come into our mandate. They come within our remit.
To the extent that the size of these sovereign premia hampers the functioning of the monetary policy transmission channel, they come within our mandate.
In other words, redenomination risk: fear of the forced conversion of one’s bonds out of the euro into another (possibly weaker) currency. Even the word itself, ‘convertibility,’ suggests the spectre of capital controls.
A delicate subject for a chief of the ECB — who begins this speech with that insistence that the euro will survive “whatever it takes” — to be seen to broach, surely.
More importantly. . . it also seems a much broader risk for the central bank to try tackling, compared to what’s previously driven its Securities Markets Programme.
How could the ECB dispel redenomination fear?
As for the SMP, you could read its return into Mr Draghi’s remarks about transmission. The SMP was always conceived as an instrument to deal with impaired transmission of the ECB’s rates. Quite often it’s been contrasted with quantitative easing on this very basis, eschewing a “precise quantitative target” for making “repairs” (buying) as and when the “mechanism” looks broken.
To date, the activating ‘premia’ for SMP buying have often seemed to be pretty specific, such as differences between the bid yield and ask yield on sovereign bonds, as much as the overall yield. If anything, this partly explains the SMP’s repeated cycle since May 2010 of buying with a bang, then in dribs and drabs, then undergoing months of silence.
This has been a disaster.
Surely a reaction to “convertibility” (or for that matter, broad “default”) risk premia would have to be very different. Maybe even unrecognisable to the SMP, and shading closer to a “target”.
Also, if you think about the fear of redenomination:
1) It’s just as present in core eurozone sovereign bonds, and could be bringing yields there down from where they should ‘fundamentally’ be (difficult as that effect is to quantify). Investors appear to believe Bunds offer redenomination insurance and/or capital preservation, because a new Deutschmark would appreciate versus the euro.
Should the ECB intervene there? How?
2) The legal possibility of forced conversion is inherent in almost all eurozone sovereign debt. Governments switched to issuing bonds governed by local law overwhelmingly after joining the euro. Local-law assets can be made to change currencies at a stroke of the legislator’s pen, and from the lex monetae principle. There’s a tension here between what sovereigns can do, and what the ECB would probably like to tell investors. It’s not unlike the SMP’s bet against sovereign debt restructuring in the assets it bought, which it got wrong in Greece.
Either way, quite a remit.