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Not So Easy: ECB Liquidity Measures May Not Be Enough

e21 | January 6, 2012

The stability of economies in the Euro Zone and their financial underpinnings certainly look to be the main threat to a robust 2012 for both the United States and the global economy. The availability of liquidity to European financial institutions is an issue of the utmost importance. As 2011 closed, the European Central Bank took steps to ramp up liquidity, by offering €439 billion in long-term refinancing operations (LTRO) at 1.0% over 3 years. As suggested in this Wall Street Journal piece, a goal of the LTRO looks to be for banks to buy higher yielding sovereign debt for use as collateral to get cheap cash from the LTRO to buy even more sovereign debt. Such a cycle would effectively soak up sovereign debt pushing yields lower and allow banks to use the basic carry trade to profit the difference in rates, thus strengthening their balance sheets.

While it is still early, the success of LTRO has been marginal at best. Rather than stimulating new investment, much of the money borrowed through the LTRO has simply substituted for interbank lending. Since the introduction of LTRO, euros in the ECB deposit facility have hit all-time highs. Instead of lending excess liquidity to weak banks, stronger banks are lending the money to the ECB, which is, in turn, lending it to the weaker banks through the LTRO. Given that the ECB’s deposit facility only offers an interest rate of 0.25% this means that banks with excess liquidity would rather accept a 0.75% lower return to avoid even short-term counterparty exposure to other banks. Not only has the ECB’s deposit facility reached record levels, but yields on sovereign debt have actually increased since the LTRO started December 20th. The yield on the Italian 10-year closed at 6.613 on that day and has since climbed roughly 4.5% to 6.916, even cracking 7.1 on December 30th.

With early indications showing the LTRO may not accomplish its goal, the ECB will have to find other means to ensure liquidity throughout EU financial institutions. Some, such as Royal London Asset Management’s head of equities Jane Coffey, feel the ECB will have to pursue a quantitative easing operations similar to that of Great Britain and the United States since the central bank has “failed to present a credible and comprehensive solution” as Coffey put it. While some may think quantitative easing is a solution, ECB president Mario Draghi has made statements which lead one to believe he does not foresee such a measure.

In a recent interview with the Financial Times, ECB president Draghi tries to make it very clear there will be no helicopters dropping money over the Euro Zone via ramped up ECB bond purchasing. The central banker went as far to comment “people have to accept that we have to, and always will, act in accordance with our mandate and within our legal foundations”. These sentiments are echoed when Draghi commented to the EU Parliament “The ECB cares about financial stability, a lot, but it has to be done without weakening the credibility of the institutions.” While these comments focus on the legal feasibility of quantitative easing, in a December 15th speech in Berlin, Draghi went as far to say “I don’t see any evidence that quantitative easing leads to stellar economic performance.” Europe’s top central banker seems to have attempted to draw a line in the sand, one which Bundesbank head, Jens Weidemann, can certainly appreciate.

While Draghi, who is just beginning his stint with the ECB, made comments indicating he does not foresee Europe copying a quantitative easing policy like that of Great Britain or the United States, an exiting ECB executive board member, Lorenzo Bini Smaghi, did not close the door on it. Rather Bini Smaghi pointed out quantitative easing strategies implemented by other central banks were in economies facing deflationary pressure, a force currently not present in the Euro Zone. Bini Smaghi, who left his post at the conclusion of 2011, commented in his FT interview “if conditions changed … I would see no reason why such an instrument [quantitative easing], tailor-made for the specific characteristics of the euro area, should not be used.” Risks are certainly to the downside for economic growth in the Euro Zone, and recent inflation data from the European Union shows inflation slowing to 2.8% in December from 3.0% in November. The “conditions” Bini Smaghi looked to be primed for a change in the coming months and year.

ECB President Mario Draghi made it a point throughout the month of December to send the message he was not a proponent of his central bank undertaking a quantitative easing operation. However, Draghi made these comments before the introduction of the €439 billion LTRO which has since seen Italian yields rise and EU bank usage of the ECB’s deposit facility hit record levels. At present it appears Europe faces downside risks to growth and little inflation pressure and will be forced to further address liquidity concerns amongst its financial institutions – and scramble to help sovereigns remain solvent. With that said, could 2012 be a year where ECB President Mario Draghi is forced to flip-flop regarding his stance on quantitative easing?

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