The ECB signalled on Friday that it would soon start retracting some of the liquidity provisions it put in place last year, in a bid to stop some of its lower-rated members from using them for financing investments in their own local government bonds – something that had helped keep European sovereign spreads tight.
The issue, we might add, was well highlighted many months ago by Edward Hugh and Claus Vistesen over at A Fistful of Euros.
BNP Paribas summed up the situation on Monday:
Banks in peripheral countries have used weak collateral to get funding from the ECB. For instance, 7% of excessive reserves provided by the ECB have gone into Greece which only represents 0.9% of EMU GDP. Greek banks have used this liquidity to buy local government paper helping sovereign spreads come down.
But with the ECB having removed the final market mechanism for punishing irresponsible fiscal behaviour (namely the CDS by allocating excess reserves into the system by accepting weak collateral), local authorities have kept the fiscal floodgates open.
The ECB has started addressing the situation by amending rating requirements for asset-backed securities in Eurosystem credit operations. In its statement the ECB suggested that ‘the Governing Council has deemed it necessary to introduce the above amendments to ensure that the Eurosystem’s requirement of high credit standards for all eligible collateral is met.
In addition, the changes, which reflect recent market developments, aim to make a further contribution to restoring the proper functioning of the ABS market.’ In result, credit will become more important for banks refunding efforts. Peripheral bank balance sheets are often seen as too long relative to equity suggesting this banks getting rid of non-essential asset suggesting the euro to rise.
This, readers might remember, echoes Willem Buiter’s long-stated point that the ECB had, via its policies, become a good bank with rubbish assets.
Consequently, given the above, it is natural the market’s attention is once again beginning to focus on sovereign credit spreads.
Indeed, as BNP Paribas point out, the issue of widening sovereign bond spreads has in fact become a global matter as central banks across the globe start eyeing exit strategies.
Spreads have been reacting like this:
Related links:
Bets rise on rich country defaults – FT
Could sovereign debt be the new subprime? - FT
ECB secret QE, or not? – FT Alphaville
It’s all Greek to the European bond market - FT Alphaville