Recently I published an article discussing Spain and the ECB's broken monetary policy transmission channel. I noted that central to the reactivation of the ECB's Securities Markets Programme (SMP) is the central bank's ability to equate sovereign debt purchases with the administration of monetary policy. Specifically, the ECB has gone about justifying bond purchases by reference to the fact that sovereign spreads are exerting a greater influence on retail rates in the periphery than the official policy rate.
In the above mentioned article, I suggested that while plausible, this justification is inherently self-serving as it allows the ECB to finance governments with the press and it permits the central bank to dictate fiscal policy through Memorandums of Understanding entered into between the rescue vehicles and periphery governments. The conclusion I came to was that, at least in Spain, the breakdown of the monetary policy transmission channel could be plausibly attributed to a liquidity crisis brought about by a steep decline in deposits which has caused lending to dry-up and domestic retail rates to rise. It is important to elaborate on this further as at first glance it may seem peculiar to assert that there is a liquidity crunch in Spain when the ECB is providing cheap funding.
First it should be noted that the very fact that the ECB has to provide these funds in the first place is evidence of a liquidity crisis. Spain's banks borrowed a record 38 billion euros from the ECB in July. However, it seems that as Spanish banks borrow more and more cash from the ECB, the central bank may be growing weary of the seemingly endless requests for liquidity. As I noted in a previous piece and as Reuters pointed out earlier this month, it would appear -- based on an analysis of the Bank of Spain's (BOS) balance sheet -- that Spain's banks have run out of ECB-eligible collateral. The section of the BoS's balance sheet ("Otros activos en euros frente a entidades de crédito de la zona del euro") which usually denotes Emergency Liquidity Assistance (ELA) rose from 1.7 million in June to 408 million in July, indicating that it is becoming more difficult for Spanish banks to access ECB cash.
In addition to this, data from Fitch (accessed via SoberLook) indicates that increasingly, U.S. prime money market funds (MMFs) have reduced their exposure to European banks from 30% of assets under management in May of last year to around 9% as of last month. This of course reduces eurozone banks' access to cash. Furthermore, Fitch notes that MMF secured lending (repos) as a percentage of total lending to eurozone banks has increased from around 17% at the beginning of 2011 to around 36% as of last month, indicating "risk aversion", and also meaning that the little bit of cash that is available increasingly is only available in lieu of collateral.
Note that both of the above two means of accessing cash involve the posting of collateral. As ZeroHedge notes, when banks experience deposit flight, their liabilities decrease in proportion to the amount withdrawn. As such, in order for the balance sheet to remain balanced, Spain's banks must decrease their assets in proportion to the deposits withdrawn or else must
"...generate EUR74 billion in shareholder equity in one month, i.e. profits - a prospect which is rather amusing"
Of course the reduction (selling) of assets to meet withdraws means the reduction of collateral and the reduction of collateral means less collateral available to post to the ECB, the Bank of Spain, or U.S. MMFs for cash. This then, represents a double dose of pain regarding liquidity: loss of deposits and loss of collateral which can be pledged for cash.
There is another downside to the selling of assets to meet the exodus of deposits. As Reuters notes, some of the assets being sold are Spanish government bonds. This of course is bad news for Spain as Spanish banks have been one of its only sources of demand for newly issued sovereign debt:
"In July alone, domestic lenders reduced their holdings [of Spanish government bonds] by EUR9.3bn, in part to meet an outflow of deposits, signaling that money is now too tight to support the sovereign."
These sales drive down prices (and drive up yields) on Spanish government bonds -- indeed this is likely one reason for the rise in Spain's long-term borrowing costs last week. This means that the selling of the bonds by the banks impairs the value of the bonds they still hold and damages the health of the sovereign, which increases the chances of margin calls on government debt the banks have already posted as collateral elsewhere. This in turn exacerbates the liquidity crisis forcing more asset sales, and on and on in yet another example of a vicious circle in Europe.
I hope this discussion has demonstrated two things: 1) that there does seem to be a liquidity crunch in Spain despite ECB funding, and 2) the situation in Europe is intractable and likely cannot be salvaged by any amount of bond purchases or official intervention. As such, I continue to recommend betting against European equities (FEZ, EWI, EWG, EWP) and against periphery sovereign debt with the notable exception of the short-term trades I have recommended (in a previous article) to take advantage of any volatility surrounding next week's ECB meeting.