Tag Archives: ECB

JKH On Paul De Grauwe’s Fiscal Arithmetic

In a recent article for VOX, Paul De Grauwe and Yuemei Ji write about potential fiscal effects of a possible asset purchase program by the Eurosystem (European Central Bank and the National Central Banks in the Euro Area). In that the authors take an extreme stand suggesting that a default by a Euro Area government on bonds held by the Eurosystem doesn’t even matter.

JKH has written a fantastic critique of the VOX article by De Grauwe and Ji.

JKH says:

De Grauwe goes on to say that because bonds held by the ECB –defaulted or otherwise – are “eliminated” on consolidation, it doesn’t matter what they were valued at on the ECB balance sheet in the first place. They may as well have been valued at zero – because they have effectively been eliminated and replaced by ECB liabilities (assumed by implication to be permanently interest free).

Thus, the balance sheet implication of De Grauwe’s treatment is that some portion of future currency issued by the ECB will be “backed” on its own balance sheet by an asset of zero value – the defaulted Italian bond. The problem is that this currency would have been issued in any event according to the demand that will arise naturally from the growth of the European economy over time (notwithstanding current depressed conditions). And so ECB seigniorage will have been reduced from what it would have been had it included the effect of good interest on Italian bonds. That reduction in seigniorage due to default is a real fiscal cost, because it reduces the profit remittance of the ECB from what it would have been in the non-default counterfactual. And the fact that the reduced seigniorage gets distributed to the residual capital holders means that there has been a fiscal transfer to the defaulting sovereign from the remaining capital holders. So De Grauwe is simply wrong on this point.

Another way to look at it is by looking at the international investment position. A default by a nonresident on a claim on held by residents is a reduction in the net international investment position and a reduction in the wealth of the geographic region. (The wealth of a nation is the sum of the value of its non-financial assets plus the net international investment position). International investment position matters as a sounder position implies that there is higher potential to raise output.

De Grauwe has another article for The Economist from today. He writes:

Since Milton Friedman we have all become monetarists. In order to raise inflation it will be necessary to increase the growth rate of the money stock. This requires that the ECB increase the money base. And to achieve the latter there is only one practical instrument, ie, an open-market purchase of government bonds. There is no other way to raise inflation than through an increase in the money base and a bond-buying programme is the time-tested way to achieve this.

It is sad that Monetarism is still alive today, despite being repeatedly been shown to be incorrect. But more importantly for the current discussion about risks, De Grauwe repeats his stand again and states it more explicitly:

This confusion between accounting losses and real losses is unfortunate. It has led to long hesitation to act. It also leads to bad ideas and wrong proposals.

So losses do not even matter!

The problem with a Eurosystem asset purchase program of Euro Area government bonds is that it achieves little. It is not a coordinated Euro Area wide fiscal expansion which is badly needed. The ECB already has the OMT program which has helped government bond yields from rising and leading to a crisis, so a QE will hardly achieve much except having an impact on prices of financial market securities. QE just diverts attention from important challenges for a unified Europe. Challenges such as how to move toward the formation of a central government.

Mario Draghi – Euro Saviour?

Recently Mario Draghi, the European Central Bank President, has been going around telling everyone that “fiscal consolidation” is the absolutely essential to resolve the Euro Area crisis, given some positive developments. Although, this view of his is known and this has had a big influence on policy, he has become more and more vocal about it in recent weeks. He has also signalled a “positive contagion” – a phrase he seems to have coined.

Here is Mario Draghi talking at the recent annual conference at Davos to John Lipsky.

If Draghi is to be believed, “fiscal consolidation” is an absolute necessity for the Euro Area to come out of the crisis.

In a recent press conference from January 10, Draghi said the same:

Question: Could Outright Monetary Transactions (OMTs) lose their magical effect in the markets if no country asks for them?

Second question: Jean-Claude Juncker has said that too much fiscal consolidation could have a negative effect on countries like Spain, because unemployment is so high. What can you say about that?

Draghi: On your first question, you do not have to ask me, ask the markets.

On the second, many comments of this type have been made about several countries in the euro area. My answer to this is that so much progress has already been made, accompanied by so many enormous sacrifices. So reverting to a situation which has been found to be untenable would not be right. We should not forget that this fiscal consolidation is unavoidable, and we certainly are aware that it has short-term contractionary effects. But now that so much has been done I do not think it is right to go back.

[emphasis: mine]

Back in July 2012, when Spanish government bond prices were plunging, Mario Draghi came up with a plan to save the Euro Area by first announcing on July 26 in a conference in London that “Within our mandate, the ECB is ready to do whatever it takes to preserve the euro,” and after a pause, “And believe me, it will be enough.”. In the monetary policy meeting on September 6, he outlined a plan by the Eurosystem to buy government bonds without any ex-ante quantitative limits, provided the nations asking this facility agree to terms and conditions – mainly on fiscal policy.

This was greeted with great optimism and the “state of confidence” of the financial markets greatly improved in the next few months. Mario Draghi eventually became the FT Person Of The Year. The fact that nations have a backstop meant that the financial sector has been more willing to finance the governments and the nations actually haven’t felt the need to use the facility so far.

At the time, there was an urgent need to do something and the European Central Bank responded positively to prevent a financial and economic collapse.

While the condition that governments asking for the ECB’s help have to meet is unavoidable for any such plan, Mario Draghi seriously misunderstands the nature of the problem. While it is true that there needs to be structural reforms so that struggling Euro Area countries become more competitive relative to their partners and aim to improve their exports to reduce imbalances within the Euro Area, a Euro-Area wide fiscal contraction will fail to achieve this in any sustainable way. Structural reforms aka wage cuts, will further deflate demand in those nations as Michal Kalecki taught us.

Take Spain for example. Its current account is coming back to balance but this has been the result of a huge deflation of domestic demand and no wonder its unemployment rate hit 26% recently. Statements such as “fiscal consolidation is unavoidable” put all the burden on weaker nations. The Euro Area actually needs a fiscal expansion in creditor nations and although a relatively tighter fiscal policy in the debtor nations compared to creditor nations, an expansion compared to the present state nonetheless. In the long term it needs to form a political union – not like the ones floated by European leaders.

The weaknesses of the Euro Area going forward has been highlighted by Charles Goodhart in a recent appearance in the Economic and Financial affairs session of the UK Parliament. Here is the link to the video.

Also, in December 2012, Draghi and the EU leaders presented a plan Towards A Genuine Economic And Monetary Union. Again this approach has the same errors as the plans floating around since decades and debunked by Nicholas Kaldor in 1971 in one of the most prescient articles ever written.  See this post Nicholas Kaldor On European Political Union. The European leaders are seriously mistaken to think of any of their plans as “genuine”.

Somehow, the Monetarist counterrevolution of the 1970s seems to have forever distorted the vision of economists and economic advisers to politicians even if they do not think they are Monetarists.

OMT! Enter The Draghi

As leaked earlier by Bloomberg, Mario Draghi in a press conference today, presented his big plan to save the world.

This will involve OMTs (Outright Monetary Transactions) – in which a Euro Area nation central government requesting aid from the EFSF/ESM will also be provided help by the ECB. Under this plan, when a nation’s government asks for financial aid (and a big if), the ECB/Eurosystem may buy government bonds in the open markets to bring the yields down.

The Eurosystem will buy bonds with maturities between one and three years and will accept credit risk on these bonds and will not ask for a seniority status in case of default. Of course, this will come with strict conditions – the government asking for aid would need to commit to a tighter fiscal policy and promise supply side reforms. There will be no upper limit to the  amount of bonds purchased by the Eurosystem.

The full details are here: Introductory statement to the press conference6 September 2012 – Technical features of Outright Monetary Transactions.

During the press conference (actually a bit before as well – after Bloomberg leaked a part of the plan), government bond yields had huge moves (e.g, Spanish ten year yields decreased 39bp). Now, if the yields do not reverse and deteriorate again soon, governments requiring help may just delay asking for aid. However, sooner or later bond yields may rise again – especially if foreigners holding the bonds start to get nervous.

My own view is that this plan significantly reduces the risk of an exit by a Euro Area member. Unlike previous plans (SMP, EFSF, ESM) this has no limit on the amount of funds needed. There is no need to wait for parliaments and courts to approve any transaction or aid.

Of course this is not a happy set of affairs. Forcing governments into retrenchment will lead to economic conditions deteriorating further. One however needs to realize that an independent fiscal policy for the troubled nations – while it (an expansion) increases national income and output – will have the adverse effect of deteriorating the balance of payments – resulting in the public debt and the nation’s net indebtedness to foreigners (and the latter is already high for troubled nations) rising without limit relative to output. The plan will look good in retrospect if it is supposed to be a bridge toward a political union with a central government.

The Eurosystem And Greek Government Debt

Some bonds of the Greek government mature on March 20. The total principal amount is €14.5bn.

The focus in the financial markets is what will happen to these securities and everyday we read about negotiations with the creditors on “private sector involvement (PSI)”. For the latest see this WSJ article Greece Private-Sector Creditors Meet in Paris.

According to The New York Times DealBook

Brokers estimate that of the 14.5 billion euros of these bonds outstanding, the largest holder is the European Central Bank, which bought these securities in 2010 at a price of around 70 cents in an early, ultimately futile attempt to boost Greece’s failing bond market. The brokers say that 4 billion to 5 billion euros of bonds are owned by hedge funds at an average cost of around 40 cents to 45 cents, with some of the larger positions being held by funds based in the United States that have large London offices.

Let us look at what may happen as far as the Eurosystem is concerned on March 20. Let’s assume that the Eurosystem holds €10bn of the maturing issue – €3bn each by De Nederlandsche Bank and the Bank of Greece and €4bn by the European Central Bank. And that the remaining €4.5bn are held by hedge funds.

Let’s assume that the hedge funds will be paid 15 cents for every € of bond held and are issued new restructured debt securities – i.e., €675m (Plus what about the final coupon payment?)

Question:  Where does Greece get the €10.675bn from?

The ECB is opposed to losses on the Eurosystem’s holdings as per this Bloomberg report from today so it may get a preferred creditor status.

The Eurosystem and the Greek government cannot roll the debt as it will violate the Treaty. So some official creditor or a group of creditors (EFSF?) will have to purchase €10bn+ of bonds from the Greek government before March 20 who will then pay €3bn each to the De Nederlandsche Bank and the Bank of Greece and €4bn the European Central Bank (plus coupons) on March 20 who will then later purchase the bonds from the group of official creditors!

The same holds even if the Eurosystem takes some loss.

The Eurosystem: Part 5

This is the fifth part of the series of posts on the description of the Eurosystem. In this post, I will discuss whatever I had kept postponing in previous posts – except central bank swaps, which I will postpone to Part 6.

[Links for previous parts: Part 1, Part 2, Part 3, Part 4]

The Euro Area is comprised of 17 nations using the Euro as the legal tender and this is referred to as EA17. In addition, 10 more nations potentially can join the Euro, so they refer to “EU27”. In the recent “summit to end all summits”, European leaders believed in Merkels and worked toward changing the Treaty. UK’s Prime Minister David Cameron refused to sign the new European accord – a wonderful thing to do.

[The UK always had an opt-out option and this move effectively divorces the UK from EU. The other nation with an opt-out is Denmark. The remaining 8 are: Bulgaria, Czech Republic, Hungary, Latvia, Lithuania, Poland, Romania and Sweden. The Wikipedia entry Enlargement of the Euro Zone has good details.]

Before the summit of political leaders, the ECB, in its monthly monetary policy meeting, decided to take steps to improve banks’ conditions: It will now conduct two LTROs with a maturity of 36 months and reduced reserve requirements from 2% to 1%. Other than that, it allowed NCBs to accept bank loans satisfying certain criteria as collateral and reduced the ratings threshold on Asset-Backed Securities. Before this, the maximum maturity of LTRO till date was 1 year.

In the press conference that followed, Mario Draghi, the President of the ECB, dashed market hopes of a more aggressive intervention of the ECB in the markets. The press conference transcript is here. However, analysts saw this as a signal from the ECB to force Euro Area governments into agreeing into fiscal contraction ahead of the summit and still expect the ECB to intervene.

Securities Markets Programme

Back in May 2010, the ECB observed that yields of a few “peripheral” government bonds were rising and it looked as if it could become a “self-fulfilling prophecy” and decided to intervene in the markets. In the ECB’s words, the Governing Council decided to:

To conduct interventions in the euro area public and private debt securities markets (Securities Markets Programme) to ensure depth and liquidity in those market segments which are dysfunctional. The objective of this programme is to address the malfunctioning of securities markets and restore an appropriate monetary policy transmission mechanism. The scope of the interventions will be determined by the Governing Council. In making this decision we have taken note of the statement of the euro area governments that they “will take all measures needed to meet [their] fiscal targets this year and the years ahead in line with excessive deficit procedures” and of the precise additional commitments taken by some euro area governments to accelerate fiscal consolidation and ensure the sustainability of their public finances.

In order to sterilise the impact of the above interventions, specific operations will be conducted to re-absorb the liquidity injected through the Securities Markets Programme. This will ensure that the monetary policy stance will not be affected.

The outstanding amount held (settled, to be precise) by the Eurosystem as on Dec 2 was about €207bn, as per this link.

This has continued to rise in recent months because of rising yields of government bonds with markets suspecting that the public debts of Spain and Italy are on unsustainable territory. So the Eurosystem intervenes frequently and the market participants quickly figure this out.

Who Buys – NCBs or ECB?

Some people have asked me – who buys the bonds: NCBs or the ECB? The answer – I believe – is both. Someone asked me if there are traders in the ECB building at Frankfurt. I do not know – perhaps a few. Someone pointed out that the ECB may be buying using the NCB as its agent. Possible. There’s another question, which nobody has asked me – does an NCB of country A buy government bonds of country B? I think so. Who decides all this is not an easy question!

For example, according to the Banque de France Annual Report 2010, (page 118 of publication, 108 of pdf)

The total amount of securities held by NCBs of the Eurosystem under the SMP increased to EUR 60,873 million, of which EUR 9,353 million are held by the Banque de France and are shown under asset item A7.1 in its balance sheet. Pursuant to Article 32.4 of the ESCB statute, any risks from the holding of securities under the Securities Markets Programme, if they were to materialise, should eventually be shared in full by the NCBs of the Eurosystem in proportion to the prevailing ECB capital key shares.

Assuming, the Eurosystem didn’t need to buy French government bonds till now, (at least till 2010 end), it seems it has purchased government bonds of other EA17 nations.

What about the ECB? Yes. According to the ECB Annual Report 2010, page 223 (page 224 of pdf):

Compare that to the Eurosystem’s consolidated balance sheet item (7.1 below) which was large compared to €17.9bn above at the end of 2010:

Also, according to Banca d’Italia’s Annual Report 2010 (page 224 of publication, 231 of pdf):

“Securities held for monetary policy purposes” was about €18bn at the end of 2010, of which about €8bn was in government bonds under SMP and the remaining covered bonds.

So to summarize, government debt is purchased by all NCBs and the ECB and the NCB purchase is not restricted to purchasing government bonds of the same nation the NCBs are located.

The same is true with the Covered Bonds Purchase Programme. The latter is somewhat equivalent to the Federal Reserve’s purchase of Agency Mortgage-Backed Securities in the United States. Covered Bonds are somewhat similar to Asset-Backed Securities such as MBS; the former are on balance sheet of the issuing bank, unlike the latter which are moved into Special Purpose Entities. The assets backing covered bonds are clearly identified in a “cover pool” and are “ring-fenced” which means that if the issuing bank closes down due to insolvency, the assets in the covered pool will be used to pay the covered bond holders, before they are available to unsecured creditors including depositors. The reason the ECB has chosen covered bonds instead of ABS is because of the strength of the covered bond lobby in Europe.

Emergency Loan Assistance

Imagine the following. A Euro Area country X’s government bond yields are at rising and the bond markets are highly suspicious of the government’s solvency. Banks are also in a bad situation and funds have made frequent flights out of the country. The banks have provided all collateral they had to their home NCB. (To be technically correct, foreign assets are pledged to the respective foreign NCB who acts as a custodian for the home NCB). The government has €8bn of payments to bond holders this week. The government has enough funds deposited at a local bank, so it can meet its obligations. However, most bond holders are foreigners. When the government pays the bond holders, the payment will go through via TARGET2 and commercial banks will run out of collateral to provide to their home NCB.

The above is one way in which banks can run out of collateral and there are other ways in which the government is not the direct reason for the outflow of funds, such as a simple capital flight. For this reason, some NCBs invented a programme called “Emergency Loan Assistance” which may not have been a terminology used in the Treaty. The relevant article which may provide an NCB with this power is the Article 14.4 of the Statute of the ESCB and of the ECB

14.4. National central banks may perform functions other than those specified in this Statute unless the Governing Council finds, by a majority of two thirds of the votes cast, that these interfere with the objectives and tasks of the ESCB. Such functions shall be performed on the responsibility and liability of national central banks and shall not be regarded as being part of the functions of the ESCB.

The situation highlighted above happened frequently with Greece during the past few months. The ELA, however was first used by Ireland in 2010. From the Central Bank of Ireland Annual Report 2010

(click to expand)

The item highlighted “Other Assets” contains the balance sheet item for Emergency Loan Assistance. More below, but before this, it is instructive to look at Liabilities:

(click to enlarge)

So, the Central Bank of Ireland’s Liabilities to the rest of the Eurosystem was around €145bn! – which is indicative of how much funds flew out of Ireland and the amount of stress the nation went through. (Ireland’s 2010 GDP was €154bn, btw). I described how funds flow within the Euro Area in Part 2 of this series.

Back to ELA. Page 104 of the publication (106 of the pdf) describes Other in Other Assets as:

This includes an amount of €49.5 billion (2009: €11.5 billion) in relation to ELA advanced outside of the Eurosystem’s monetary policy operations to domestic credit institutions covered by guarantee (Note 1(v)). These facilities are carried on the Balance Sheet at amortised cost using the effective interest rate method. All facilities are fully collateralised and include sovereign collateral as well as a broad range of security pledged by the counterparties involved.

The Bank has in place specific legal instruments in respect of each type of collateral accepted. These comprise: (i) Promissory Notes issued by the Minister for Finance to specific credit institutions and transferrable by deed, (ii) Master Loan Repurchase Deeds covering investment/development loans, (iii) Framework Agreements in respect of Mortgage-Backed Promissory Notes covering non-securitised pools of residential mortgages, (iv) Special Master Repurchase Agreements covering collateral no longer eligible for ECB-related operations and (v) Facility Deeds providing a Government Guarantee. In addition, the Bank received formal comfort from the Minister for Finance such that any shortfall on the liquidation of collateral is made good. Where appropriate, haircuts (ranging from 5.5 per cent to 80 per cent) have been applied to the collateral. Credit risk is mitigated by the level of the haircuts and the Government Guarantee. At the Balance Sheet date no provision for impairment was recognised.

You can find details of these in this blog post Irish Central Bank Comfort at the blog called Corner Turned, which is now inactive.

Oh yeah … How does the Irish NCB provide the loans? Hint: Loans make deposits.

FT Alphaville has two nice posts (among others) on ELA in Greece: Sundry secret Greek liquidity [updated], Hooray for, erm, Greek ELA?. The first one pokes on how the Bank of Greece – Greece’s NCB – hides the item under “Sundry” and the second one one how Greek banks’ net interest income were higher than expected – the reason being that expensive deposits were replaced by cheaper NCB funding!

This concludes this post. In Part 6 – the final one  – I will discuss central bank liquidity swap lines with the Federal Reserve.

Update: Compared ECB’s holdings of “securities held for monetary policy purposes” with that of the Eurosystem (consolidated)

Edited 18 February 2012


Mario Draghi is talking to press reporters now, as I write.

The ECB reduced reserve requirements to 1% from 2% and plans to do Long-term Refinancing Operations with maturity up to 3 years (i.e., it will lend banks for a term of three years). It also relaxed collateral standards.

The markets are in absolute roller coaster. Mario said that IMF borrowing from the Eurosystem and lending the governments is a violation of the spirit of the Treaty and repeatedly said monetary financing of governments is not allowed because the Treaty embodies the best tradition of Bundesbank and that fiscal retrenchment will enhance confidence of the markets! Central bankers can’t give up their dogmas, can they?

And to make his point clear, he again repeatedly said “no financing of governments” and while reporters tried no end to get something from him, he said “I wish all our leaders the best, and the ECB is here — which does not mean the ECB will respond” !

Here is FTSE MIB (FTSE’s Index for Italian Stocks)

(Source: Google Finance)

Here’s a chart of EURUSD from my iPhone CitiFX app

This photograph from FT is the best