8/13/2019 63693159 JPM ECB Can Act as a Safety Valve but Will Not Solve the Crisis Research Note 2011 08-26-666075

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Economic Research

Global Data WatchAugust 26, 2011

1

JPMorgan Chase Bank, London

Greg Fuzesi (44-20) 7777-4792

greg.x.fuzesi@jpmorgan.com

ECB can act as a safety valve,but will not solve the crisis The ECB is unwilling to buy peripheral government se-

curities in size or to intervene for very long

This reluctance reflects deep concerns about moral haz-

ard, political legitimacy, and inflation risk

With Euro area governments still reluctant to significantly

enlarge the EFSF or introduce Eurobonds, many are looking

to the ECB as the only institution capable of solving the

regions sovereign crisis. Some suggest that the ECB

should simply ramp up its purchases of government bondsthrough its Securities Markets Program (SMP), which it

could do by creating more reserves (i.e., printing money).

However, this strategy would bear huge risks and the ECB

has little appetite for following it. Instead, the central bank

sees clear limits of its policy toolsit is willing to act as a

safety valve against short-term stresses in financial markets

but it cannot solve what is ultimately a crisis of fiscal policy

and solvency. As a result, the ECB will always force the

ultimate resolution of the crisis back to politicians.

How big are the safety valves?

It is not hard to see why some may argue that the ECB

could expand its balance sheet much more aggressively in

response to the sovereign crisis. The total size of its bal-

ance sheet has increased around 50% since 2007, which

compares to an increase of around 200% for the Fed. In

addition, around 80% of the increase has been driven by

the more obscure and inactive balance sheet categories,

such as valuation gains due to the higher price of gold and

increases of the investment portfolios, which are held

partly for operational reasons and as counterparts to the

central banks capital. In contrast, the !110 billion of gov-

ernment bond purchases make up just 5% of the balance

sheet at present. And despite providing as much liquidity to

banks as they demand, the aggregate amount lending is nota lot higher than it was in 2007 (although changes in the

distribution of this lending matter at least as much as the

total amount, see box).

Why is the handbrake on?

In our view, there are three interrelated reasons for the

ECBs caution. The first is moral hazard. The ECB wants

troubled banks to restructure their balance sheets and raise

capital so that they can quickly return to private funding

markets. And it wants governments to deliver the difficult

Economic Research Note

The ECBs two balance sheet supports

In response to the stresses caused by the sovereign crisis,

the ECB is using its balance sheet as a safety valve in two

ways.

Unlimited provision of liquidity to banks. Since Octo-

ber 2008, the ECB has been meeting banks demands for

liquidity in full. In late 2009, this led to a doubling of the

total loans made by the ECB to banks (to !900 billion),

as the drying up of interbank lending forced all Euro area

banks to hold larger liquidity buffers with the central

bank. Since then, the pressures have mainly led to shifts

in the distribution of liquidity, rather than to increases in

the overall amount. In particular, as certain groups ofbanks (e.g., peripheral ones) have come under pressure,

the flow of private funding from bad to good banks

has increased the reliance of the former on central bank

liquidity and reduced it for the latter. If such imbalances

are across countries, they can show up as the infamous

!325 billion exposure of the Bundesbank to peripheral

central banks via the TARGET2 payment system. In ef-

fect, the German banks have seen an inflow of private

funding (and hence reserves), allowing them to reduce

their borrowings from the central bank, while peripheral

banks have had to top up their reserve accounts by bor-

rowing more. In this way, the Eurosystem is acting as

lender of last resort, given that the interbank market is notdistributing funds from good banks with surplus funds

to bad banks.

Asset purchases.From mid-2009 to mid-2010, the ECB

bought !60 billion of covered bonds to support this im-

portant bank funding market. And through its SMP, it

has so far bought !110 billion of peripheral government

bonds. The !35 billion of Italian and Spanish bond pur-

chases have lowered 10-year yields by around 1%-pt in

these countries over the past two weeks.

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8/13/2019 63693159 JPM ECB Can Act as a Safety Valve but Will Not Solve the Crisis Research Note 2011 08-26-666075

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2

Economic Research

ECB can act as a safety valve, but will solve

the crisisAugust 26, 2011

JPMorgan Chase Bank, London

Greg Fuzesi (44-20) 7777-4792

greg.x.fuzesi@jpmorgan.com

How about turning the EFSF into a bank?

Daniel Gros (CEPS) and Thomas Mayer (Deutsche Bank)

have proposed setting the EFSF up as a bank to address itslimited lending power. It would fund IMF-style adjustment

programs by issuing bonds as normal, but would tackle li-

quidity crises affecting otherwise solvent states by using

the potentially unlimited liquidity from the ECB. Effectively,

it would purchase government bonds of the country being

attacked by markets and then repo them with the ECB. It

could intervene quickly, in size and without having to pre-

fund. Such lender of last support could prevent a liquidity

crisis from turning into a self-fulfilling solvency crisis. Nev-

ertheless, there are major problems. In particular, there is no

real difference between this scheme and the ECB buying

directly. As liquidity crisis are almost always associated

with some concerns about solvency, it would not circum-vent the need for difficult fiscal adjustments. And that im-

plies the same kind of context, which is making the ECB

hesitant about large-scale monetization of debt. Hence, we

do not see this as a more appropriate form of large-scale

purchases of bonds.

fiscal adjustments and reforms that will allow them to regain

access to market funding. The ECB has also appeared keen

to sponsor moves toward greater political union, including

sharing of fiscal capacity, as a means to stabilize the region.

The ECB worries that it would weaken the incentives for

banks and governments to make these necessary adjust-

ments, if it provides liquidity too generously to banks and if

it keeps government bond yields too low. It cannot turn off

the liquidity tap for banks altogether, as this would cause a

banking crisis. But, it is making relatively short forward

commitments about providing unlimited liquidity (currently

until 1Q12) and is reluctant to lend at long maturities (the

six month tender it offered in early August has been de-

scribed as a one-off). It is also leaning on regulators and

the banks themselves to adjust and is still working on a

special liquidity facility, which would likely provide liquid-ity for troubled banks for longer periods but against strict

conditions and possibly at a penalty rate. For governments,

the ECB has pushed them to take responsibility for stabiliz-

ing bond markets and has made clear that its renewed bond

purchases are only indended to fill an implementation

vaccuum until the EFSF can take over.

The second constraint is the risk of inflation. The purchase

of government bonds leads to an expansion of the ECBs

balance sheet, even if the newly created reserves are subse-

quently sterilized in the form of one-week fixed term

deposits. Recent experience in the US and UK does not

suggest any mechanical link between such balance sheetexpansions and broader money aggregates, or a destabiliz-

ing impact on inflation expectations. But the context in

which the ECB is acting is different. The ECB does not see

a need for balance sheet expansion to deliver price stability.

And with markets questioning sovereign solvency in the

region, the ECBs purchases of bonds may increasingly re-

semble monetary financing of deficits, which the EU Treaty

forbids and which Germans fear. If people abandon the euro

and move into real (e.g. property and gold) or foreign as-

sets (e.g. Swiss francs), rising asset prices and a falling ex-

change rate could lead to high inflation. Such behavior may

seem unlikely, but it is not uncommon for some German tab-

loids to issue advice to their readers along such lines.

The third restraint is political legitimacy. To some, the

ECBs bond buying is a neat way of by-passing the politi-

cal process that is slowing down the fiscal response to the

crisis. This ignores the fact that Germany is dragging its

feet for a reasonits population and government think that

the bailouts only make sense if the periphery does its

homework. The ECB does not have the political legitimacy

to purposefully undermine this position by purchasing ever

larger amounts of the peripheral bond market, a point made

this week by the German President Christian Wulff. The

SMP purchases (!110 billion so far) and the liquidity sup-

port to peripheral banking systems (around !325 billion so

far) already imply a huge socialization of liabilities across

the region. Should this result in losses for the ECB, the cen-

tral bank would need to be recapitalized or retain future prof-

its. Politicans in the core countries know that their taxpayersare already on the hook for the ECBs exposures, and are

unwilling to sponsor them increasing indefinately.

The ECBs actions remain a huge source of support to the

region and the central bank is justifying them with reference

to its mandate: ensuring financial stability by supporting

banks, and delivering price stability by improving the func-

tioning of the monetary policy transmission in the bond

market. Its independence, however, is strongly rooted in

European treaties, which mean politicians cannot coerce it

to ramp up or even continue with its SMP purchases against

its wishes. While the ECB will continue to act as a short-

term safety valve against market stresses, it can use its inde-pendence to push governments in the right directions

setting limits to its interventions in terms of quantity or the

duration of time it is prepared to act. And the ECBs reluc-

tance to go all in with a much larger commitment to mon-

etize peripheral bonds reflects a deep tradition of stability-

oriented policy, inherited from the Bundesbank. This means

recognizing that central bank liquidity can only buy time but

not solve a crisis of fiscal policy and solvency. And it

means accepting some near-term stress if it helps to reach a

more stable medium-term outcome.