Dungeons and Draghi

Yesterday, 06 of September 2012, Mario Draghi the Italian President of the European Central Bank (ECB) announced the new measures that the central bank will adopt in order to prevent the collapse of the Eurozone. The markets immediately reacted to the news with euphoria. The best performer was IBEX 35 (Madrid) with a 4,9% gain, followed by FTSE MIB (Milan) 4,3%, CAC 40 (Paris) 3,06%, DAX (Frankfurt) 2,41% and FTSE (London) 2,11%. Is this euphoria justified?

First, lets see what exactly Mario Draghi said and which will be the measures that the ECB will adopt from now on. Lets begin with the first press release, in which the ECB comments the new measure called Outright Monetary Transactions (OMT):

http://www.ecb.int/press/pr/date/2012/html/pr120906_1.en.html

The OMT allows the ECB to buy sovereign bonds of European countries in the secondary market. Therefore, if a country finds itself in a difficult situation, the ECB can intervene in the secondary market in order to lower the interest rates of its sovereign debt. Why is this important? The interest rate at which the sovereign debt is exchanged in the secondary market determines, or influences, the interest rate that is paid in the primary market. To put it simple, when a state spends more than what it earns it has a deficit that has to be filled by borrowing money. When a state borrows money it goes to the primary market and asks for the money. Investors, depending on their perception of the probability that the state will payback the borrowed money, will ask for a higher or lower interest rate. After the money is borrowed, the debt is exchanged in the secondary market depending on the perceptions that investors have about the state ability to payback the borrowed amount. Therefore, there is a strict connection between primary and secondary markets. But lest go back to the OMT. This mechanism allows the ECB to buy sovereign debt on the secondary market with “no ex ante quantitative limits”, that is it can buy whatever quantity it considers necessary. This part was the part that caused the euphoria in the markets. However it is better to read all the press release in order to understand the conditions attached to this purchases. Draghi in his speech insisted a lot on this conditionality and the first part of the press release is called Conditionality:

“A necessary condition for Outright Monetary Transactions is strict and effective conditionality attached to an appropriate European Financial Stability Facility/European Stability Mechanism (EFSF/ESM) programme. Such programmes can take the form of a full EFSF/ESM macroeconomic adjustment programme or a precautionary programme (Enhanced Conditions Credit Line), provided that they include the possibility of EFSF/ESM primary market purchases. The involvement of the IMF shall also be sought for the design of the country-specific conditionality and the monitoring of such a programme.”

This means that the ECB will buy sovereign debt only on the condition that the country already applied to the EFSF/ESM program or to the Enhanced Conditions Credit Line (a precautionary program). This is very important because it means that before any intervention of the ECB, given that the state already applied to one of these programs, the receiver of the help will be intervened by the troika and will be asked to comply with strict conditions like it happened with Greece. At the moment, therefore, nor Italy nor Spain would be eligible for the OMT. Only if they first apply to the EFSF/ESM or ECCL, asking for these mechanisms to buy their debt in the primary market in exchange for structural reforms, the ECB can go on and buy their bonds in the secondary market in order to decrease their interest rates. Moreover the ECB specifies that it can stop buying bonds of any country if the country is not complaining with the agreed terms and is not doing the necessary structural reforms. This thing is important because Rajoy and Monti are doing everything they can in order to not apply to these programs and be intervened by the troika, losing their sovereignty and losing popularity among their voters.

In the second part of the release, the ECB states that “transactions will be focused on the shorter part of the yield curve, and in particular on sovereign bonds with a maturity of between one and three years”. Buying only short term bonds (between one and three years) is a signal that the ECB still has fear of inflation in the longer term so it buys bonds that mature in maximum three years and at maturity the liquidity poured into the market will be absorbed again in an effort to avoid a future increase in inflation.

In the third part (Creditor Treatment) the ECB makes a statement that could be really controversial and could create problems between the ECB and the Bundesbank:

“The Eurosystem intends to clarify in the legal act concerning Outright Monetary Transactions that it accepts the same (pari passu) treatment as private or other creditors with respect to bonds issued by euro area countries and purchased by the Eurosystem through Outright Monetary Transactions, in accordance with the terms of such bonds.”

This is crucial. It means that if there is any loss, that is some country cannot payback its debts, the ECB will face losses exactly as other private creditors. When Greece defaulted and restructured its debt, the ECB did not accept to face losses on its holdings and this increased the losses faced by other private creditors. A simple example: if a country owes 100 in debt, 50 to private creditors and 50 to the ECB, and it can payback only 60, if the ECB is considered pari passu everyone faces a haircut of 40, that is the ECB will write down 20 and recognize 30 in its balance sheet and the same will do the private creditors. However, if the ECB states that it has priority and will not face losses, only private creditors will have a write down of 40 and a balance sheet value of 10, instead of 30. The fact that the ECB ranks pari passu is important because private investors are not considered junior creditors, will be safer and will ask lower interest rates. However, we have to remember that the equity base of the ECB is really small and in case of a default of between 50 and 80 billions, its equity will be wiped out. If this happens, the recapitalization of the ECB will be over the shoulders of the other states that are not defaulting and especially over the shoulders of the majority “shareholders”, that is Germany and its taxpayers. Therefore, the decision to rank pari passu will be not easily accepted by German taxpayers.

In another point the ECB states that the liquidity created by the OMT program will be “fully sterilized”. That is, the ECB will reabsorb the liquidity selling other assets or increasing the amount of money that private banks deposit at the ECB. I think that the sterilization will be a problem and will be not that easy to put in practice. If the sterilization will be done through the selling of other assets, it will be difficult to do because it will sink the value of those assets. In this case the ECB will incur losses and there is the risk of sinking the market of these assets (other sovereign debt, MBS etc.). If the ECB sterilizes attracting deposits from banks it will have to do it increasing the interest rates on these accounts and therefore incurring in losses. However, the most problematic aspect is that if interest rates will go up in the future as the economy exits the crisis, banks will withdraw the money and put it in more profitable projects, increasing the liquidity in circulation and the probability of an increase in inflation (difficult to sterilize).

The good news is that the ECB will be more transparent than before and will publish weekly the market value of the OMT transactions and monthly the breakdown of these transactions by country. That is, we will know how much the ECB purchased in the secondary market (weekly) and which bonds it purchased (monthly).

In another press release, “Measures to preserve collateral availability”, the ECB “decided to suspend the application of the minimum credit rating threshold in the collateral eligibility requirements for the purposes of the Eurosystem’s credit operations in the case of marketable debt instruments issued or guaranteed by the central government, and credit claims granted to or guaranteed by the central government, of countries that are eligible for Outright Monetary Transactions or are under an EU-IMF programme and comply with the attached conditionality as assessed by the Governing Council”. This statement recognizes that banks in the peripheral countries are really thirsty and in deep need of liquidity. Due to the connection between governments and their financial institutions European banks have filled their balance sheet with their government bonds, replacing the absent foreign demand. For example, Italian banks are filled with Italian sovereign bonds, Spanish banks with Spanish sovereign bonds and Greek banks with Greek sovereign bonds. Therefore, now banks are filled with sovereign debt that has been downgraded by rating agencies and this debt till now was not eligible to be posted as a collateral in order to obtain the much needed liquidity. The ECB now is stating that it will accept sovereign bonds of states that are eligible for the OMT program or under EU or IMF intervention. In this way Greek banks that need liquidity can go to the ECB and ask some liquidity posting as a collateral Greek sovereign bonds, even if these bond have credit ratings below the investment grade.

Conclusion

Markets reacted as the ECB announcement was good news but actually it is not. The ECB recognized the gravity of the European situation and decided to adopt extreme measures in order to prevent the collapse of the Eurozone. However, these measures can be very dangerous for the ECB and for European future stability, especially if mechanisms of sterilization will not work given that the collateral posted will be of worse quality and difficult to resell in order to absorb the desired amount of liquidity. Moreover, the Bundesbank has yet not agreed on this extreme measures and they have still to be approved by Germany. Therefore, at the moment, these measures are only theoretical and it is possible that Germany will refuse to support this measure at the moment of truth, when the ECB will be willing to buy unlimited amounts of sovereign bonds putting in danger German taxpayers money and risking an increase in inflation, fact that is not seen under a positive light by the Germans. The risk of inflation is not present at the moment because the destruction of credit is faster than the money creation by the ECB, banks are undercapitalized and have not creditworthy borrowers. However the difficult sterilization of the increased money supply could pose an inflatin problem in the future.

The positive reaction of the market is not sustainable and the problems in the Eurozone are far from over.

ECB's Balance Sheet tutorial (Assets)

ECB Balance Sheet: some notes.

The European Central Bank (ECB) is the institution responsible for the monetary policy within the European Union (EU). In this post I will analyze in some detail the balance sheet of this institution (account by account) to explain the meaning of the different entries.

Anyone who is interested in the information provided by the ECB about its balance sheet can go to the webpage:

http://www.ecb.europa.eu/press/pr/wfs/2012/html/fs120612.en.html

Every week the ECB publishes the balance sheet and anyone can see what happened during the week, which accounts changed, and what is the meaning of this change. I think that this brief tutorial can help readers to understand what is going on in the present crisis, given that the Central Banks is one of the most important agents in the economy. I will begin with the asset side of the balance sheet going, as it is presented in the webpage, from the most liquid asset to the less liquid one. This is the asset side of ECB balance sheet as of 01/06/2012 (in billions):

Assets	01/06/12
Gold and gold receivables	432,70
Claims on non-euro area residents denominated in foreign currency	243,60
Receivables from the IMF	86,08
Balances with banks and security investments, external loans and other external assets	157,52
Claims on euro area residents denominated in foreign currency	49,08
Claims on non-euro area residents denominated in euro	28,00
Balances with banks, security investments and loans	17,59
Claims arising from the credit facility under ERM II	-
Lending to euro area credit institutions related to monetary policy operations denominated in euro	1.115,52
Main refinancing operations	51,18
Longer-term refinancing operations	1.063,63
Fine-tuning reverse operations	-
Structural reverse operations	-
Marginal lending facility	0,71
Credits related to margin calls	0,00
Other claims on euro area credit institutions denominated in euro	250,59
Securities of euro area residents denominated in euro	605,11
Securities held for monetary policy purposes	280,82
Other securities	324,29
General government debt denominated in euro	30,58
Other assets	257,82
Total assets	3.002,59

Gold (432,7): The most liquid asset in a central bank balance sheet is gold. Even if economists (i.e. Keynes) and famous investors (such as Warren Buffett) think that gold is a “barbarous relic” central banks have a lot of gold in their balance sheet (some have more and some have less). The importance of gold is that it is an asset that is not a liability of another counterparty. If ECB owns dollars, it faces counterparty risk (even if it is considered minimal) because the dollars are liabilities of the Federal Reserve (FED) while gold is an asset that does not have any counterparty risk. In the present economic crisis some central banks, especially emerging countries’ ones, have been increasing their gold reserves because in the present deflationary situation, gold has a good behavior. Usually gold is seen as a protection against inflation, but it is not true. Other assets offer better protection than gold in an inflationary situation (commodities such as oil, food, meat etc.). However, in a deflation and in a credit crunch (situation in which there is a huge destruction of credit) there is an increase in counterparty risk (the risk that a counterparty defaults on its obligations) and the demand for gold increase and as a consequence its price. So gold is a good asset in a situation like the one we are facing right now. We need to remember that gold was money till the expropriation that occurred in the beginning of the 20^th century. It looks like many years ago, but we need to remember that the last official link between gold and paper money was broken in the seventies with the suspension of gold payments from the Nixon administration. I will not extend more on money and gold because it is an argument for a full post or even an article or a book. Lets concentrate on ECB’s BS.

Claims on non-euro area residents denominated in foreign currency (243,6): These claims are assets held against the International Monetary Fund (86 billion receivables) and other assets held against foreign banks and other foreign economic agents (157,5). If ECB buys dollars, or buys some other liquid asset denominated in foreign currency, it puts these dollars or assets in this account. Here we can find also loans denominated in foreign currencies or deposits at foreign banks.

Claims on euro area residents denominated in foreign currency (49,8): the concept is the same but these assets are denominated in domestic currency (euros).

Claims on non-euro area residents denominated in euro (28): same concept but these are assets in euros that are liabilities of non-euro area institutions. I will not extend on these accounts because these are not the important part of the ECB’s balance sheet and their amount is not that relevant.

Lending to euro area credit institutions related to monetary policy operations denominated in euro (1.115,52): This is by far the most important account of the BS from a quantitative point of view (it represents 37% of the BS) and from the qualitative point of view. This is where most of the magic of money creation happens. By far the most important account of this part is the “Longer Term Refinancing Operation” (35% of the BS). Here the ECB buys (or “lends” because the agreement presupposes that sometime in the future ECB will sell again these assets to the same banks) assets to private European banks in order to expand the money supply. The process is simple: when the ECB needs to inject liquidity in the system it buys assets from private banks or, if we want to be more precise, lends money to private banks in exchange for good collateral. How it pays for these purchases? Well, it creates liabilities such as physical paper euros or just new deposits (liabilities of the central bank but assets of the private bank) that private banks can use to lend or purchase assets. As a collateral the ECB used to ask good assets, i.e. assets with triple A rating or sovereign bonds, considered (mistakenly) risk free. The central bank wants good collateral because if the private bank cannot repay the loan, the ECB still has a good asset that can sell in the market in order to get back the euros and decrease the money supply. So the central bank can decide how much money supply there is the economy buying (or lending against a collateral) more or less assets and increasing or decreasing the quality of the assets that it accepts as a collateral. We are not saying that the central bank can decide exactly how much money and credit will be supplied in the economy. The CB can only increase or decrease the monetary base (physical euros and deposits of private banks held in the CB) but it cannot decide how much credit the banks will expand, given that credit expansion depends on well capitalized banks, viable investment projects and creditworthy clients (these three things are in short supply now and this is the reason why we see that even if the monetary base is expanding we cannot see an increase in bank lending). So this is the account you want to analyze closely when your are looking for monetary expansion. Usually the ECB used to lend just for one day, one week or some months, but now, in December and February, it decided to lend longer term (3 years) because of the problems private banks had to refinance themselves in the market. The longer term loans and the decrease in the quality of the assets can, and probably will, be a problem for the ECB because if it wants to decrease the money supply or if the private banks will default on their loans, it will be more difficult to sell these assets and recover all or part of the loan (this is a big problem given the small capital base of the ECB, we will see that when we will analyze the liability side).

Other claims on euro area credit institutions denominated in euro (250,59): it is difficult to understand which are those other claims because the ECB does not specify more the content of this account. Probably the ECB puts here something that it does not want to specify. This is not pure conspiracy theory, the ECB itself told that it would not disclose some data to not induce panic in the market (smart guys, this declaration itself induces panic, doesn’t it?). Apparently in this account the ECB puts something called ELA (Emerging Liquidity Assistance). Under the ELA each European country’s central bank can lend to their private banks that have urgent liquidity needs and have not adequate assets to use as a collateral in order to ask for liquidity directly to the ECB. The ELA should be quite controversial because it allows central banks other than the ECB to create money supply without ECB’s direct control. This is justified saying that each country’s CB bears the risk of the private bank defaulting, i.e. the ECB does not bear any risk. However, if the central bank in question cannot repay the loan (a possible scenario), the ultimate credit risk is borne by the ECB (this means the risk is borne by other European countries, especially the sounder ones). Curiously this account increased by around 100 billions on the 20^th of April of 2012 and this increase was almost exactly offset by a decrease in the Other Assets account. I do not know the exact explanation for this movement.

Securities of euro area residents denominated in euro (605,11): this entry is split into two accounts: Securities held for monetary policy purposes (281) and Other securities (324). In the second account there are investments in not specified securities. The ECB does not specify what it puts in this account. The other one (Securities held for monetary policy purposes) is filled of PIIGS’ sovereign debt. When the market is turbulent the ECB buys directly in the secondary market Greek, Portuguese, Italian, Irish and Spanish sovereign debt and puts it in this account. The ECB does it in order to increase the market value of peripheral sovereign debt and decrease the interest rates at which these countries can refinance themselves in the market. As we told before this is not the only way the ECB can buy European sovereign bonds. Even if the ECB by mandate cannot buy directly sovereign bonds in the primary market (to reduce the incentive of monetization of debt), the ECB can buy this debt in the secondary market, or accept it as a collateral in private bank lending and indirectly refinance European states given that these private banks can take the money, buy sovereign bonds and then go to the ECB and rediscount them to get more money.

General government debt denominated in euro (30,58): in this account there is government debt of all European countries put there when the ECB was created, in order to capitalize it.

Other assets (257,82): this account is what here in Spain we would call “cajon de sastre”, that could be literally translated as Tailor’s booth and means a place where you put a lot of stuff without any order whatsoever. So I really do not know exactly what’s in it. The ECB’s guys say that it is in my own interest and for my safety that I do not know the content of this account. Do you believe that?

Total assets (3.002,59): Total assets are 3 trillion euros.

I hope that now it is clearer how and where to look in the ECB’s balance sheet. However, the most important thing is to look for changes in these accounts and understand what these changes mean. Let’s see how some of this accounts evolved during the last years.

 In this first graph we can see how the BS expanded from 2009 to 2012. It increased by 50%, so there has been a huge expansion of some or all the accounts of the BS. This is not good. It could lead to future inflation because there is more money and credit in circulation and people who did not receive this money first will experience an increase in prices without a correspondent increase in income. This is how citizens will pay for the present economic crisis, with the dilution of the purchasing power of money. We have not inflation right now because credit has been destroyed at a faster peace than money has been created (no “velocity” of money or money multiplier), however the increase in the monetary base could have inflationary effects in the future. Therefore, an increase in total assets is bad, not only for this reason but also because it can lead to a central bank default. However, not only the quantity matters, but also the quality.

If there is an increase in liquid assets it could be a good thing because the risk of loss is less probable. However the huge increase in assets can be explained by the increase in lending to euro area institution against worse and worse collateral and an increase in the purchase of peripheral countries’ sovereign debt. Therefore not only the quantity of the BS has increase but also the quality has decreased due to lending more money against worse collateral and buying distressed countries’ debt.

In this graph we can see how the ECB supported directly (in the secondary market) the peripheral countries buying their sovereign debt. Sovereign debt purchases were less than 50 billions till 2010. Then, with the Greek crisis and the “contagion” effect to other countries that were in a similar situation, the ECB tried to contain the increase in sovereign yields buying their bonds. Now this account’s value is around 280 billions. If comes out that this debt is worth just 50% of face value, the ECB should assume an impairment loss of 140 billions, more than its 85 billion euros of capital. Therefore, in this scenario, the ECB should declare bankruptcy or should be recapitalized by European governments (especially by Germany and the most creditworthy states).

I know that it is not a complete discussion of central bank’s balance sheet, but I think it can clarify a little bit how to read it.

In the next post we will analyze the liability side of the ECB’s balance sheet.