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Event response
The ECB is being overtaken by events. Mr Trichet
would probably concur having seen that:
• The IMF was welcomed into the Greek
rescue package when he had been reported
as having said, “If the IMF or any other
authority exercises any responsibility instead
of the eurogroup, instead of the
governments, this would clearly be very, very
bad” (Senat television); and
• The ECB decision to suspend the minimum
credit rating threshold for Greek debt came
after Mr Trichet said on 14 January, “We will
not change our collateral framework for the
sake of any particular country. Our collateral
framework applies to all countries concerned.
And that has been said already by the Vice-
President, by me and by colleagues. That is
crystal clear.”
The ECB is reacting to events and it cannot be
blamed for that; it should be praised for helping the
Greek banks, for example. But these episodes show
that its forward vision is restricted and that it is not in
charge of developments. Rather, it is reactive.
Further challenges lie ahead. First is probably the
phasing out of liquidity injections. Basically,
unconventional measures are responses to financial
stress. When OIS/BOR came in, VIX declined and
bank CDS shrank; with financial stress on the wane,
it was sensible to start to withdraw liquidity. Now
stress is back and it is no longer sensible for the ECB
to continue tightening through scaling back liquidity
provision. We would cite in support of this a tendency
for BOR/OIS to widen, the increased participation at
the regular MRO and the marginal rate of 1.5% at the
recent 3-month LTRO despite massive overprovision
possibilities at that repo by the ECB.
The potentially most toxic development is for banking
stress to appear in economies where the sovereign is
under pressure. If a sovereign cannot save itself,
how can it save its banks? Such a situation can only
lead to losses on sovereign debt that hurt the banks,
in turn hurting the sovereign through increased
bailout costs and likely lower future growth.
It is best not to get into such a vicious spiral. The
most effective way to avoid this is through massive
liquidity provision to the banks on cheap terms and
for a long period to remove liquidity worries.
Change of direction
A key event on the horizon is the expiry of last June’s
12-month fixed term repo. We would advise replacing
this with another fixed term repo of six or preferably
twelve months duration at 1%. Would this be another
ECB climb-down? Yes, but it would be a sensible
one.
Then there is the issue of the ECB buying the
government debt of countries in trouble. Increasingly,
market participants’ view this as very likely. Why?
Because they see the real possibility of funding
stresses and are sceptical of first, the ability of the
Greek programme to run its full course and second,
the willingness of Germany in particular to stump up
for another bailout after Greece.
If these circumstances arise, so the argument runs,
there may be two choices: the ECB buys the afflicted
government’s debt, or there is default. The first looks
the lesser of two evils, as a default would set off a
domino reaction that ultimately could lead to severe
strains on EMU itself and at least could lead to
further defaults and stress in the banking system.
QE problems
There are of course objections to the ECB effectively
providing QE not to help the general economy but to
help regional governments in the euro area:
• ECB monetary policy should be decided on
the basis of the needs of the aggregate area,
not a small proportion of it;
• Monetary policy should be driven by
monetary considerations and should not be
driven by fiscal policy;
• Printing money because governments cannot
finance themselves can be a precursor to
inflation;
• At the least, the ECB’s credibility would be
damaged;
• If there is a solvency problem in a country,
the ECB has not got the balance sheet to fix
that – only other governments can sort it.
Dealing with a liquidity crisis alone is more
defensible, but Greece’s liquidity crisis has
stemmed from solvency worries;
• The step may be one too far for Germany.
Recourse to the constitutional court would be
likely with large-scale monetisation
reminiscent of the Weimar republic. Such a
move could make EMU even more unpopular
within the population, which has already
manifested its opposition to plans to bail out
Greece;
• As the ECB has often pointed out with
reference to US and UK QE, it may be very
difficult to back out of such holdings;
Paul Mortimer-Lee/Ken Wattret 7 May 2010
Market Mover
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