Easing the pressure: How the ECB has helped place a funding buffer

Despite the successful auctions this week, the eurozone still faces the same old problems if the ECB stops its QE-by-proxy

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On closer inspection, the eurozone still faces the same old problems
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Simon Miller
On 20 January 2012 12:47

So did I get it wrong? Are we seeing signs of recovery as evident by the French bond-sale this week? As much as I would like to say “oui, I’m afraid the answer will eventually be “non”.

Markets can be wonderful, organic, unmappable entities that always have the ability to do something completely different to what logic expects.

And so was the case with bond sales this week. Spain sold €6.61bn of four, seven and ten-year bonds exceeding the maximum target of €4.5bn while France shifted €7.97bn of notes, just short of its maximum target, with the average yield on the benchmark two-year notes sliding to 1.05 percent.

So one in the eye for us evil Anglo-Saxons and our conspiracy to do down the euro for the diversion-seeking eurocrats.

On the surface it does indeed appear that the markets are ahead of Standard & Poor’s (S&P) over the ability for France and Spain – and Italy which also had a successful auction – to fund themselves and avoid default.

So what is going on? Why, when all indicators point to defaults in Greece and Hungary with the subsequent risk of contagion, do the markets see light at the end of the tunnel?

I doubt they really do. What we are seeing are the effects of the European Central Bank’s (ECB) bond-purchasing program. There has been a wake-up call at the ECB that has seen a massive growth in the accumulation of assets – so much so that it now holds more assets relative to GDP than the US Federal bank.

Through the Securities Markets Program and its Long-Term Repo Operation (LTRO), the ECB has been essentially operating a quantitative easing (QE) program despite the objections of the Germans.  

Although it doesn’t buy government bonds direct from sovereign countries – after all that is against the rules and we can’t be having that can we? – it buys the bonds from the euro-financial sector in return for one-week deposits while the LTRO allows it to borrow government bonds from banks in exchange for three-year loans.

To put that into perspective, the Bank of England’s (BoE) QE sees it buying government bonds from the UK financial sector in exchange for overnight reserves – monetising the debt.

Pretty similar and it could go a long way to explaining why there is demand for the debt. Banks and other financial services could be buying up the bonds to exchange for liquidity from the ECB – QE by proxy if you will.

However, there are still major risks to this system especially when it comes to keeping the system fluid.

Despite a slight fall in overnight deposits, €420.94bn last night, eurozone banks actually parked a record €528.18bn on Tuesday with the ECB – essentially taking a loss for the safekeeping for their assets.

Unlike the BoE’s QE, the default risks still lie with the banks, so the sovereign debt exposure still stays with the banks. Basically, banks are still concerned with what exposures their fellow bankers have to eurozone sovereign debt and are reluctant to lend to each other.

With austerity measures being put in place around the eurozone, if banks are not lending to each other, the sugar of liquidity on the austerity pill isn’t there. Although banks have more cash, it is not being fed into the system which in turn will act as yet another drag on the euro-economies that need recovery measures the most such as Portugal.

Furthermore, unlike the BoE which is expected to increase QE later this year as inflation falls, the ECB is implicitly against continued bond purchasing. The €217bn purchase of peripheral eurozone country debt since 2010 by eurozone central banks has already led to the resignations of former German central bank president Axel Weber and former ECB executive board member Jürgen Stark. There is not the political will to keep this going. 

So eventually it will stop.

Now I am against QE, I feel it is a dangerous measure to implement that eventually could damage an economy but if you are doing it, then at least get it right.

The ECB QE-by-proxy is a shortstop measure and a quick-fix solution that hasn’t solved anything. Banks are still not lending, countries still have debt issues and the underlying problems in the eurozone are still there waiting. When the ECB stops its buffering of the funding system, expect to see sharp spikes in funding costs for those countries that think they have survived their S&P downgrades.

Markets are unpredictable in their behaviour sometimes, but the continued failure to address the fundamental problems of the eurozone is depressingly predictable and the initial pleasure at beating a downgrade could become a forgotten memory – that is if events in Greece and Hungary don’t come to the boil first.

Simon Miller is the Editor of Financial Risks Today. He tweets at @simontm71

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