Just How Big Is The ECB's Bazooka?

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Includes: FXE
by: Shareholders Unite

According to many (including ourselves), much of the euro crisis results from a change in perception of the market about euro-denominated bonds. While these were once considered risk-free, talks about (and then policy implementation of) Greek "haircuts" has awoken the market to the fact that there is no lender of last resort standing behind these bonds and the euro zone countries effectively borrow in a foreign currency.

That has led to a huge shift in risk perception, consider the following cases. Italy's public finances have only marginally deteriorated the last couple of years, but the risk perception of Italian bonds has changed much more.

For instance, Spain's public finances are, in many ways, in better shape than those of Britain or the US, but it pays vastly higher interest rates as the latter borrow in their own currency and have a lender of last resort behind the bonds (see figure below).

Click to enlarge

The increased risk perception is leading banks to off-load debt of countries perceived to be in danger:

European banks are planning to dump more of the 300 billion euros they own in Italian government debt, as they seek to pre-empt a worsening of the region's debt crisis and avoid crippling write downs - a move that could scupper the European Central Bank's efforts to bring down soaring yields. [Reuters]

So the idea is to let the ECB assume the lender of last resort as well, and these risk perceptions will vastly reduce. However, there are a couple of objections to this line of reasoning.

ECB's "Bazooka"

First, one can wonder how much fire power the ECB actually has. How big is the bazooka of the ECB really? Apart from having just 83 billion euro in equity capital, the ECB has another 383 billion euro in so-called revaluation reserves. The latter refer to increases in the price of its assets (like gold) which have not yet been taken on the books.

But the real fire power comes, of course, from the ECB's ability to print money; that is, to electronically credit accounts of counter-parties in transactions (like bond purchases) with money that wasn't there before (this ability to create money is called "seigniorage," which technically is the difference between the value of money and the cost to produce it, but the latter is effectively zero here).

However -- as even adherents of the so-called modern monetary theory, or MMT, admit -- there is an upper limit to that ability in form of the inflation danger:

The true limit on seigniorage is therefore set by the future amount of money which will be held willingly by the population as the economy grows in the future, assuming that the inflation target of 2 per cent is attained and interest rates are normal. [Gavyn Davies, FT]

Independent calculations from Willem Buiter (Citigroup) and Huw Pill (Goldman Sachs) arrive at 2-3 trillion euro in seigniorage capability, against which there are 2.7 trillion euros (and counting) of Italian and Spanish outstanding bonds -- so they would be covered, just about.

Adding Greek, Portuguese, and Irish bonds would make it rather tight; adding French bonds would push the ECB over the edge, or so it seems. However, this is not the end of the story, the ECB has some tricks up its sleeve.

Sterilization

For starters, it could take the money creation away by so-called "sterilization" transactions. In this case, the money creation from the ECB bond purchases are routinely creamed off by tendering 1-week fixed-term deposits (although these sometimes are not completely successful).

But the principle stands, by sterilization, selling other assets that cancel the money creation of bond purchases, it could avoid much of the inflation danger and prolong the bond purchases for much longer.

In fact, it's hardly a surprise that the ECB has been doing just that, as its Teutonic DNA (like being governed by a single mandate to achieve price stability) makes it rather allergic to anything that can even remotely be seen as inflationary.

Let inflation creep up

Another way out is just to let a little inflation into the system. Many argue that this could have beneficial effects; inflation reduces the real value of outstanding debt, hence it would over time reduce the size of the sovereign debt problem. Even more importantly, perhaps, is that it would take some of the hard edge of the adjustment problem within the eurozone. The so-called PIIGS countries not only face public finance trouble and steep financing cost, they (except Ireland) have also seen their labor cost rise 30% in relation to Germany, which has made their economies uncompetitive.

With no possibility to devalue and the hard money approach favored by the Germans, and the ECB essentially forcing enormous deflation (or internal devaluation) on the PIIGS to regain competitiveness, it would be that much easier if Germany would reflate. Now all the adjustment burden is on their already very weakened economies and we see from Greece how this internal devaluation can turn into a vicious cycle.

But, alas, the Germans are so allergic to inflation, that this isn't going to happen anytime soon.

More words, less action

The ECB could simply announce a policy shift. This is likely to be more effective. If the ECB would announce that it would engage in unlimited bond purchases or announce some yield beyond which they won't let bond yields rise, they would almost certainly be very credible and market pressure to sell bonds would quickly disappear.

We've seen something similar when capital flight to Switzerland caused the Swiss franc to explode higher, only for the Swiss central bank to announce an upper limit to that rise. So far, that has held as the Swiss central bank can sell Swiss francs in a similarly unlimited way as the ECB can create euros, and since the Swiss have so much to lose from a spiraling upwards of their currency that the announcement was deemed credible.

If the ECB would announce itself as the lender of last resort for euro-denominated sovereign debt, it would, in fact, simply become like most (if not all) other central banks who already perform that function (like the Bank of England, the Fed, and the Bank of Japan).

Poker game

There is another objection against unlimited ECB interventions (whether announced or real). It is likely to offer the wrong signals to offending countries and create a moral hazard problem in which these countries stalk their necessary (but unpopular) reforms and rely on the ECB to bail them out of their debt problems

This is one of the reasons why the ECB is such a reluctant bond market interventionist. Apart from inflation fears (which are misplaced, we think), it wants to keep maximum pressure on the peripheral countries to engage in budget cuts and economic reforms, and that is, to a considerable degree, understandable.

So while unlimited intervention (or better, an announcement of such policy) would be able to get rates down quickly (even without much actual intervention), the fear of the likes of Italy not forcefully addressing its economic problems keeps them from doing so. However, as The Economist has argued:

Italian bonds do not have to be restored to risk-free status—they only need their yields dragged low enough for Italy to remain solvent.

Life -- even for central bankers -- is just full of trade-offs, isn't it?

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.