We’ve seen charts like the below before, but they are still striking:
That’s a Goldman Sachs snapshot of European central bank liquidity. As you can see, it basically falls off a cliff come summer 2010, when the the ECB is due to withdraw its emergency liquidity operations.
The central bank’s exit strategy has become something of a worry for markets in recent months, especially given the turmoil occurring in Greece, Spain and Italy — some of the biggest users of the liquidity facilities.
Indeed, the looming withdrawal of these facilities, as well as the possible downgrades to its credit ratings, is one of the things that kicked off the current Greek crisis.
As the FT’s Gillian Tett writes in her Friday column, echoing an FT Alphaville comment in December:
Back in the autumn of 2008, after the collapse of Lehman Brothers, the ECB loosened the rules which govern how banks can get central bank funds. In particular, it let banks use government bonds rated BBB or above in ECB money market operations, instead of merely accepting bonds rated A-, or more.
This was initially presented as a “temporary” policy, slated to last until late 2009. But last year the ECB extended the policy until the end of 2010. Thus, during 2009, banks which were holding Greek bonds have been merrily exchanging these for other assets via the ECB. This, in turn, has helped to support Greek bond prices (and, by extension, Greek banks that hold a large chunk of outstanding Greek bonds).
Until recently, many observers thought – or hoped – that this policy would be extended again, perhaps until 2011 or beyond. For although Greek debt currently has a credit rating that meets the old ECB rules, there is a good chance the debt will be downgraded this year. This creates the risk that Greek bonds will be excluded from any newly tightened ECB regime.
The trick for the ECB will be to withdraw its liquidity support, without risking a sizeable shock to countries like Greece, or Portugal, or Spain. If however, the situation gets so bad the central bank feels it can no longer do that, there is always the possibility of a policy reversal. A withdrawal from liquidity withdrawal, if you will.
As Goldman analyst Erik Nielsen puts it:
While Greek policies will largely determine the spread that investors demand to hold Greek debt, the base rate is likely to move gradually higher as the ECB continues its exit strategy. In our base line scenario, which assumes that contagion from Greece across Southern Europe will be somewhat contained, the ECB will gradually drive EONIA higher towards 1% to regain control of the interest rate instrument. We discuss the various ways that it could achieve this gradual increase in the following article.
That said, if we are wrong in assuming that the contagion from Greece to the rest of Southern Europe will be temporary and reasonably well-contained, then it would no longer be less than 3% of Euro-zone GDP (Greece) that is under severe stress, but potentially 20%-30% of Euro-zone GDP. In that case, we would expect ECB policies to be adjusted to ease the financing, first by pausing in its exit strategy, and, if needed, by reversing course and re-instating longer-term financing.
But for the next 4-8 weeks, this will be all about the design and implementation of additional fiscal measures in Greece, about the timing of financial help from the rest of the Euro-zone, and about policy measures and implementation in other peripheral countries.
Related links:
ECB liquidity cliff risk – FT Alphaville
How do you say vicious circle in Greek? – FT Alphaville
The ECB as `liquidity monster’ – FT Alphaville