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A critique of the ECB’s liquidity policies


Originally published on Eurointelligence on Febrary 24, 2011. It was translated into Italian by La Repubblica and Sinistra in Rete, also quoted by Portuguese blog Jugular. The article was discussed to death on European Tribune.

At the end of last week the financial community was awash with speculation surrounding a more than 10-fold increase in volume of the ECB’s Marginal Lending Facility (MLF), which allows Eurozone banks to satisfy their minimum reserve requirements by borrowing them overnight from the ECB at a penalty rate. Neither the ECB nor private banks usually comment on their operations but, given the longstanding state of hair-trigger alert in the money markets and the fact that the high MLF borrowing dangerously persisted into the weekend (giving traders 48 hours of idle time to mull over something like this can be disastrous), it was probably a good idea for the Irish to admit it was them _whodunit_, especially since there was actually no cause for alarm and the banks responsible are already being restructured. As reported by the Financial Times and the Irish Times on Saturday, this episode was simply due to Anglo Irish Bank and Irish Nationwide Building Society releasing some assets from being held as weekly collateral for the ECB’s Main Refinancing Operations to being held as daily collateral for the MLF, in preparation for a sale of €15bn-worth of deposits as part of the wind-down of the two troubled banks.

This incident may have been much ado about nothing, but it provides an opportunity to take a closer look at the liquidity conditions in the Eurozone interbank market, and the picture isn’t pretty. On Thursday, when the best one could do was canvas informed speculation, Reuters’ Kirsten Donovan quoted James Nixon of Societe Generale saying:

The process of withdrawing liquidity is leaving the market short … Potentially the continued provision of unlimited liquidity and the desire to sterilise bond purchases may be in conflict.

The liquidity conditions in the money markets remain, indeed, tight, in no small part due to the ECB itself which, in its deflationary zeal, is draining an increasing amount of cash from the money markets to offset its modest purchases of sovereign Euro bonds. Since the bond purchases (obscurely dubbed ‘Securities Market Programme’ by the ECB) began on May 10 2010, the ECB has been auctioning one-week deposits in an amount equal to its bond purchases with the explicit intent to take liquidity away from the banking system.

One source of puzzlement amid last week’s speculation was the lack of any “signs of distress” in the interbank money market, but the fact is that the interbank rates have been inching steadily higher for some months to the point that the Euribor 1Y rate is now touching the 1.75% level of the ECB’s MLF and may be about to exceed it. This is a very unusual situation: over the past 10 years, this has only happened in 2008, between April and year-end, so we may rightly characterize the current liquidity conditions as very tight.


The precise timing of this rising trend supports a correlation of upwards pressure on short-term interbank lending with the ECB’s “sterilization” of its sovereign bond purchases. In fact, for the 8 months prior to May 10, when the ECB started buying sovereign Euro bonds, the Euribor rates were essentially flat at all maturities. Since then, they have been rising in fits and starts while the spreads between different maturities stay roughly constant. Therefore, protracted upwards pressure on the overnight interbank market rate, “without signs of distress”, is sufficient to take longer-term interbank lending rates at or above the MLF rate, as has finally happened. In countries (including, but not limited to, Spain) where variable-rate mortgages indexed to the 1Y Euribor are customary, such a rise in interbank interest rates near the bottom of the recession could spell trouble. This makes the ECB’s restrictive monetary policy quite reckless.

Since the Securities Market Programme started last May, the ECB has “failed to fully sterilise its bond purchases” on two occasions, first at the end of June and then from December to February. It does appear that this past week the ECB succeeded in draining €76.5bn of liquidity to match its Security Market Programme holdings. Each “failure to fully sterilise bond purchases” has worried the inflation hawks, and the more recent and longer one has led the ECB to suggest the EFSF now in place should be buying the bonds in order to relieve the ECB of this task. However, there’s no way this is inflationary, quite the contrary – that money is not circulating. In effect, the ECB is taking money from the private banks with one hand in order to buy bonds off them with the other. Since these bonds are already eligible collateral for the weekly ECB refinancing operations, buying the bonds has nearly no monetary impact, so coupled with the weekly deposit-taking the net effect is contractionary. The fact that the “sterilization of bond purchases” coincides with the recent upwards trend in the interbank lending rates supports this view. It is even possible that the same banks are selling bonds to the ECB and putting the proceeds in ECB deposits, which would imply that the ECB is paying the private banks a premium for the privilege of storing their sovereign bonds. Given that the ECB is paying up to 1% for the offsetting deposits instead of charging 1% for repoing the bonds at the MRO, each “failure of sterilization” indicates that the ECB is trying to drain more than the entire spare liquidity of the private banking system for one-week lending. That this spare liquidity is less than €80bn should give the inflation hawks pause.

The idea that sovereign bond purchases need to be “sterilized” to prevent inflation illustrates that the ECB has a very peculiar concept of sovereign debt, in fact very different from its idea of private debt. Consider the ECB’s own Covered Bond Programme. In May 2009, with nary a peep from anyone or the apparent need for “sterilization”, the ECB decided to buy, potentially in the _primary_ market, up to €60bn of asset-backed bonds issued by Eurozone commercial banks. A year later the mere _suggestion_ that the ECB might purchase a comparable amount of sovereign debt was (and continues to be) met with such hysteria that prominent members of the ECB Governing Council went so far as to break collegiality and publicly contradict the ECB’s stance claiming, wrongly to boot, that secondary market purchases of sovereign bonds were prohibited by Treaty (it is primary market purchases that are barred by Article 123 of the Consolidated Lisbon Treaty). The constituent rules of the Eurozone appear to be based on the bizarre idea that sovereign debt is toxic until such time as it has been sanitized by going through the bid-offer spread of a major investment bank, while privately-issued covered bonds are pristine, even at issue.

If the MLF is tapped again in the next weeks, it may be entirely as a result of the ECB’s wrongheaded monetary policy, which treats the Euro as it it were on the gold standard and not a fiat currency. Consider that last week the slumbering market woke up and began a new round of attacks on Eurozone sovereign debt, reportedly leading the ECB to buy Portuguese bonds. As the ECB increases its matching deposit-taking, interbank rates will likely continue to inch higher making the MLF increasingly less expensive compared to interbank lending. One way for the ECB to “solve” this problem might be for it to raise the marginal lending rate away from the Euribor 1Y rate to force any MLF borrowing back onto the interbank market, which would only put additional upwards pressure on interbank rates (impacting, dangerously, retail variable-rate debt service). I wouldn’t put it past them to try.

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