Leading players in liquidity drama long for final act

Three central banks have been at the vanguard in the War On Illiquidity. Their views differ on how to get the global economy and financial sector back on track. But all are making asset purchases at unprecedented rates, and they are likely to sink or swim together. Solomon Teague reports.

  • 28 Sep 2011
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"A central bank has a unique ability to create or destroy liquidity through the use of its balance sheet." So said Charlie Bean, deputy governor for monetary policy at the Bank of England, describing the role of a central bank at a speech in Canberra in July.

According to Bean, the primary objective is to ensure that the supply of that liquidity is consistent with the smooth functioning of the real economy. And from this follow the two core tasks of a central bank, "the maintenance of broad stability in the price level, nowadays often enshrined in a formal numerical target for inflation; and supporting the process of financial intermediation during times of stress, including acting as lender of last resort to solvent, though temporarily illiquid, financial institutions."

But not all central banks were created equal. There are crucial differences between the three key central banks that constitute the main players in the current liquidity drama, in terms of the political mandate they have been given.

At opposite ends of the spectrum are the European Central Bank and the US Federal Reserve. The ECB has an unambiguous mandate: price stability. Having lived through hyperinflation in the 1930s, Germany and other European countries are particularly sensitive about price stability, which goes a long way to explaining the ECB’s cautious use of the money press.

The Federal Reserve too must maintain price stability but it also needs to promote growth. With the two goals not always in harmony, the Fed’s priorities are more open to interpretation, making the personality of its chairman a more decisive factor.

"Ben Bernanke believes in a strong policy response, partly due to his training and his studies as a student of the Great Depression," says Charlie Diebel, head of market strategy at Lloyds Bank Corporate Markets. "He is very happy to undertake quantitative easing, and is likely to be quick to implement QEIII if he feels it is needed."

The Bank of England, while closer to the Fed than the ECB in terms of mandate, is somewhere between the two. Unlike the Fed, it has an inflation target, which is the senior partner of its dual responsibilities.

The BoE’s liquidity provisioning measures caused an expansion of its balance sheet from around £80bn in 2006 to around £250bn in early 2010, according to its own figures. The Fed’s balance sheet has expanded from around $900bn to more than $2.5tr over the course of the crisis.

The ECB’s measures have seen a more modest increase in its balance sheet. As of August 26, it stood at just over €2tr, up from €1.9tr at the start of the year and €1.28tr at the start of 2008. A conservative estimate of the net present value of the ECB’s future base money issuance is close to €3tr, according to a research note from Citi in August. That assumes it will not allow inflation to breach 2%.

European support is also now offered through the European Financial Stability Facility. The EFSF has lending power of €440bn but that could soon be expanded to around €1tr, Citi says, allowing it to assume some of the liquidity support responsibilities that currently fall to the ECB.

Embracing change

Bean noted that the crisis had seen the BoE and the Fed, as well as other central banks, go from making "predominantly short-term loans to banks against generally only the safest collateral, mainly highly rated government debt," to "providing larger loans, of longer tenors, against a wider range of collateral." The lesson to draw, he concluded, is that "in a crisis, central banks need to show flexibility."

All three central banks have indeed been flexible, but while the Fed and the BoE have been unequivocal in their use of quantitative easing to support their economies and banking sectors, the ECB has shown itself to be the most inherently conservative institution. The ECB’s acquisition of peripheral sovereign bonds is unprecedented for the bank, says Diebel, but does not constitute a departure from its previous role. Rather, it is a new strategy for implementing its traditional objectives.

"The ECB’s mandate will stay the same unless there are treaty changes to specifically authorise it," he says.

The ECB’s job involves a careful balancing act of the sometimes mutually exclusive concerns of the 17 governments and treasuries in the eurozone. Critics of the ECB have long argued that it is essentially just a tool used to enact pro-German economic policy. There is truth to that view, agrees Marco Valli, chief European economist at UniCredit in Italy. Since Germany constitutes 30% of the GDP of the eurozone, this is consistent with the bank’s mandate, he says.

At first glance the ECB’s asset purchases look similar to the QE pursued by the Fed and the BoE but there are important differences. While QE is explicitly intended to support prices and prevent what many see as a necessary correction in various asset markets, the ECB intentionally sterilises its purchases, offsetting some of the effects of its actions and ensuring the money supply has not been increased. It does this by taking one week deposits from the banks at a fixed rate, thereby removing liquidity from the system.

"The ECB is not trying to flood the market with liquidity in the same way the Fed and the BoE are, it is only trying to bring sovereign bond spreads down to levels that it feels are more consistent with the fundamentals of the countries issuing those bonds," says Valli. "Therefore the ultimate goal is not to increase money supply, but to restore the proper functioning of the monetary policy transmission mechanism."

The need to sterilise is the only real constraint to the ECB’s support of sovereign bond markets — as well as the covered bond markets — with its asset purchase programme. The more liquidity it pumps, the harder it gets to sterilise its purchases and the greater the risk of inflation, says Valli.

Where is the money going?

While debate has raged around the moral justification for liquidity interventions in free market economies, there is little doubt that central bank asset purchases have saved the finance sector — and by proxy the global economy — from at least partial collapse. In maintaining the status quo the programmes have been a resounding success.

But in the US, the glut of liquidity in the system sits awkwardly with a lack of enthusiasm for most assets. Holdings of cash are at all-time high levels but investors still need to invest in something. Banks, for all their problems, are a beneficiary of that imperative.

"There is nowhere else to put it," says Nigel Myer, bank credit strategist at Lloyds Bank Corporate Markets. "Banks’ short end looks OK compared to a few years ago and maturity transformation is still a core function of a bank."

In fact, there are other places for it to go: emerging markets, particularly Brazil, Russia, India and China, continue to be hot, with money originating from the biggest foreign central banks — which is having a detrimental impact on those economies, says Sylvain Broyer, head of economics at Natixis.

"From the US perspective, a currency crisis in Brazil is preferable to an economic crisis in the US," he says. "The policy is helping at home but it is causing serious problems abroad, where monetary authorities have lost control of their own monetary policy."

In Europe there have been differing responses to the liquidity injection. In Portugal a general distrust of asset markets is encouraging people to keep their money in banks, so the deposit bases of local banks are quite healthy. That is creating a mismatch, with plenty of assets on the short side but a lack of longer term assets to invest in, says Diebel. Conversely, in Greece, banks are witnessing deposit outflows, with investment going into non-euro deposits outside Greece, or euro deposits away from Greek banks, he says.

So which is better, the ECB’s approach or the Fed and the BoE’s? "It’s too early to say," says Diebel. "The US has seen some recovery so its actions are somewhat vindicated, and although the recovery has been soft it would surely have been worse off if it had not responded as it did."

Equally, the ECB’s response looks appropriate in its own context. "It has had to contend with the sovereign debt crisis which has restricted its actions, and while its bond purchases may not be doing much to help the peripheral eurozone countries, the cost is already so high that the extra 25bp or so on top doesn’t make very much difference," says Diebel. Though the sheer number of floating rate mortgages in Spain does perhaps make that country particularly sensitive to ECB actions, he concedes.

The central banks are also operating in very different circumstances. The ECB is effectively providing life support while national governments attempt to resolve the real causes of the crisis.

"The eurozone crisis will not be resolved until authorities accept full fiscal union," says Broyer. "The crisis in Europe ignores the economic fundamentals. Europe has a relatively low debt yield and the region as a whole does not run a current account deficit the size of the US or UK. The difference is the political organisation, which the market recognises is not viable."

The Fed and the BoE are semi-autonomous from their respective governments but at least have only one treasury to contend with, compared to the 17 member states that the ECB must navigate. The Fed is also assisted by the US dollar’s reserve currency status: around 35% of the buying of its Treasuries is being done by central banks around the world, in particular Japan and China. Conversely, the overwhelming majority of euro bond purchases are made by European treasuries themselves, meaning that, as the crisis deepened, a greater burden fell to the ECB.

Wanting to tighten

The ECB’s concern about inflation is demonstrated by its eagerness to tighten monetary policy, and it began tightening at its first opportunity in early 2011. With German inflation running above 2%, the ECB felt it had to act. Some feel this was ECB president Jean Claude Trichet’s greatest mistake.

"The problem started out in 2008 as a banking crisis but it evolved into a sovereign debt crisis as governments underwrote bank debts," says Broyer. "But in recent weeks we have seen it evolve back into a banking crisis again, like a boomerang. It is no coincidence that trend has started in Europe, which has been most eager to normalise its yield curve."

Not everyone agrees with this analysis. "Monetary tightening is not exactly helping the markets but neither is it the main problem," says Diebel. "The main problem is a lack of confidence."

The market in Europe is being driven principally by politics, capital and fear, he says. "On days when more proximate concerns are off the radar screen then, yes, liquidity is an issue. But mostly other factors are more important."

Citi seems to concur. "Even the most pessimistic reading of the situation does not justify the panic and fear that we are seeing," its analysts wrote in August. "Much of this response appears to reflect bad information and ignorance." If so, all may be well if the central banks keep pumping the liquidity — but this offers no insight as to when confidence may return.

The US has yet to start tightening policy and is unlikely to consider such a course of action until it sees evidence of inflation, of which there is currently precious little, says Diebel. "Tightening would be a big change of direction and I don’t think it is likely any time soon," he says. "I think the US will want to see how the sovereign situation in Europe unfolds before it takes that step."

Even the ECB, with its own reservations about inflation and its unwillingness to follow the Fed down the path of QE, has concerns about the prospect of the Fed unwinding too soon.

"A faster than expected unwinding of the Federal Reserve’s balance sheet, together with the start of monetary policy tightening, could lead to increased volatility in various money market segments," the bank wrote in its Financial Stability Review in June. "It might also pose a risk of spillover to other financial markets, in particular the fixed income markets. Such risks would be greater if the Federal Open Markets Committee were to apply a tighter monetary policy more quickly than anticipated."

Life support

And what about the central banks’ exit strategy? They will have amassed unprecedented balance sheets by the time markets reach sufficient health for them to unwind their positions. How easy it will be to unwind those positions, and how long that will take, remains to be seen.

"As people pay down their debts they will reduce their deposits with the banks so there is a natural unwind," says Myer. "But if the economy is going to get used to lower levels of debt then it is going to need more growth to drive returns in other assets."

But there is concern that the asset purchase programmes are addictive for the banks, which may struggle to cope once the crutch is removed. Bankers and analysts worry that the termination of central banks’ liquidity provision and the resulting withdrawal symptoms will be destabilising.

The central banks are in uncharted territory. It is impossible to assess the risks they are taking on, or the likely repercussions of their actions, with much confidence. The models used by commercial banks are of no use. "The ratios that apply to commercial banks’ risk management departments do not apply to central banks," explains Valli. "Because central banks can print money, they have a much higher limit for leverage and other factors that determine risk. So it is not easy to say at what point the ECB is taking on too much risk."

The ECB plays down the problem. "The ECB has retained a high degree of flexibility in its future decisions because most of the measures taken can be easily unwound once normal financial conditions are re-established in a self-sustained manner," the bank said in article entitled The ECB’s Non-Standard Measures – Impact and Phasing Out. But that assumes financial conditions will normalise.

"The banking system has been in the Emergency Room for a number of years and it is only the actions of the central banks that is keeping the patient alive," says Diebel. "The doctors cannot walk away until the patient is healthy." With the operation more than three years in already, there is little prospect of it completing any time soon, he warns.

The banks will eventually be strong enough to survive without central bank support, Diebel predicts. "The central bank positions are big, but they aren’t that big as a proportion of the size of the markets as a whole," he argues.

But the ECB acknowledges the dangers of continuing the current course of action for too long, which might "encourage excessive risk taking by financial market participants, distort incentives and delay the necessary process of balance sheet adjustment by private and public sector entities," it said in its article on phasing out its liquidity support. "This would ultimately undermine price stability over the medium term, with detrimental effects on economic growth."

"The ECB’s non-standard measures will continue to be phased out in line with the ongoing normalisation of conditions in financial intermediation," the bank added. But some would question evidence suggesting market conditions are normalising. For all the talk of the support measures being temporary, there looks to be no prospect of them ending any time soon.

"We face a situation very similar to the one Japan has been in," says Broyer. "QE has failed to provide that growth stimulus, to create a money multiplier — that increased money base has had little impact on the real economy." All the central banks, for their differences, face having to provide continued stimulus for the foreseeable future, not because it is promoting growth but because it is primarily propping up the finance sector, he says.

There is no simple solution. "The ECB’s liquidity support for the banking sector cannot replace the measures that need to be taken by national governments, regulatory bodies and the financial sector itself to ensure the solvency of individual banks and the sustainability of the banking sector’s business models, also at higher interest rates," the ECB wrote.

It’s a telling assessment, and one that Trichet has spent much time reinforcing. Over to the politicians.
  • 28 Sep 2011

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