Here’s something to ponder after what seems to have so far been an unproductive meeting of European finance ministers in Brussels.
Deutsche Bank’s Gilles Moec is putting the ‘Plan B’ in the ECB — with a suggestion for a shiny new eurozone liquidity mechanism.
That rather differs from some earlier thoughts — including, for instance, RBS’s idea that the ECB should just ramp up its bond-buying Securities Market Programme. As a reminder, the Bank has already extended its three-month Long-Term Refinancing Operations (LTROs) and Main Refinancing Operations (MRO) to boost liquidity.
Still, according to Deutsche, upping the SMP is still a last resort option for the ECB:
… The [LTRO/MRO] mechanism is indirect. True, full allotment on 3 month repos is an incentive for banks to purchase peripherals’ government securities to post as collateral. However, they can choose from other sources of collateral they may find more appropriate given their particular circumstances. For instance they could resort to ABS, as long as they are investment grade, which would help them to continue to offload loans from their balance sheet. Alternatively, they could target “strong signature” government bonds, instead of peripheral sovereign paper, to avoid the risk of potentially disruptive margin calls from the ECB.
In principle, “simply” massively scaling up the SMP program would be an obvious avenue to bypass this difficulty. Jean-Claude Trichet this week was keen to stress that this could be done at any time, creating a “backlash risk” for any investor positioning on a further increase in sovereign bond rates. However, getting the ECB into “QE2 territory” for any prolonged period of time may be difficult. From their point of view, it is probably a last resort solution which they may implement too late, once the deterioration in market conditions has reached a point of no-return where the very existence of the monetary union would be threatened.
Of course ‘super-sizing’ the SMP isn’t exactly QE, but it veers uncomfortable close to it for many members of the ECB. And remember the SMP was always was sensitive.
What then to do if eurozone jitters persist? Here’s Deutsche’s idea:
Targeted long term ECB repos could be an acceptable compromise in our view. Instead of “blind” LTROs, without control over the collateral chosen by the counterparties, or as a complement to them, the ECB could launch 12 month repos of investment grade government paper below AAA rating assorted with a “margin call holiday” until the expiry of the repo. This would specifically incentivize banks to purchase peripheral govies.
Since the govies would return to the market automatically at the expiry of the repo, governments would in effect be given 12 months to demonstrate to the market their capacity to address their fiscal issues, which reduces the moral hazard. Still, we acknowledge here a risk of spiral too, since peripheral governments could bet on the idea that the ECB would be forced to renew these “targeted repos” at expiry, very much like the central bank was finally obliged by the deterioration in market conditions to maintain full allotment after January 2011.
No kidding.
There are also coordination issues involved here, but we’ll focus on just that spiral notion. Above is a proposal which would arguably inflate the ECB’s already bloated balance sheet while taking risk management (via that margin holiday) off the table.
As it is, Deutsche Bank has a few suggestions it thinks will avoid that problem:
- First, we think that as a condition of the implementation of the targeted repo the ECB would make it clear that the policy rate is set to rise at some point in 2011, aggregate conditions in the Eurozone permitting. This would be appropriate given the robust data flow in core Euroland countries, stronger expected inflation and the re-depreciation in the euro. Of course this would make the recovery of the peripherals more complicated, but higher short term interest rates would be offset by regained control over the long end of the curve. The anticipation of higher policy rates would appease the authorities of the core countries – where public opinion may start to react negatively to tentative inflationary pressure – while gradually increasing the cost of further targeted repos.
- Second, this program of “targeted repos” should be complemented by commitments by the peripheral countries to take long-awaited decisions. To use Spain as an example, ECB support via the targeted repo would provide a safe environment to the sovereign allowing for finally letting the FROB (the government guaranteed bank recapitalisation vehicle) to meaningfully issue on the market to strengthen market confidence in recapitalised Spanish banks …
- Third, the margin call holiday is here to provide visibility to the banks but the risk would not ultimately be borne by the ECB. At expiry the ECB’s counterparty would still need to recognise a loss if the value of the bond has fallen in the meantime. This is an acceptable risk to take. The “second line” of countries currently affected by market tensions, such as Spain and Italy, given time, have in our views very good chances of demonstrating the sustainability of their public debt.
A question mark here lies on the Portuguese case. We suggested in last week Focus Europe that Portugal is likely to face strong pressure from the European peers to trigger the rescue package as Ireland did. Indeed, this country has accumulated significant imbalances, in particular a persistently large current account deficit hovering around 10% of GDP which reflects severe underlying competitiveness impairment. They probably need direct support and close monitoring. Otherwise, this could be a candidate to repeated ECB intervention. We think that placing Portugal under the protection of the IMF/EU umbrella might be one of the conditions put by the ECB to any far-reaching support it may give to the sovereign bond market.
The whole thing sounds like an extension of that ‘onwards, upwards, forever European liquidity‘ meme to us, but no doubt markets would be chuffed.
At least for a while…
Related links:
LTROpprobrium - FT Alphaville
If not the ECB, whom? – FT Alphaville