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Sudden rises in very short-term market interest rates – the cost of borrowing overnight, for instance – usually spell trouble. Soaring Chinese interbank borrowing costs at the end of last year highlighted the central bank’s difficulties in curbing the most egregious financing practices of the country’s banks.
Less noticed beyond a few specialist circles, the European Central Bank has this year also seen market interest rates rising – not as acutely as in China, but possibly sufficiently to force a change in strategy.
As in China the rises reflect shifts in the banking landscape – something the ECB is keen to encourage. But the risk is of rising market rates feeding through into higher borrowing costs for businesses and consumers when economic growth remains weak. An unwanted, premature monetary policy tightening – via higher market interest rates – could tip the eurozone into a dangerous deflationary slump.
The ECB’s problem is largely self-inflicted. When the eurozone debt crisis was at its most intense in late 2011, Mario Draghi, the new ECB president, decided to flood banks with a “wall of money”.
Eurozone banks were urged to take advantage of cheap three-year ECB loans, or “longer-term refinancing operations”, but to ensure sufficient take-up the ECB sweetened its offer with an early repayment clause. Rather than being locked into holding ECB funds on their books for the full three years, banks could repay after a year.
The sweetener helped ensure the LTROs were successful in averting disaster: banks borrowed more than €1tn and the eurozone crisis eased, at least temporarily.
By the time the early repayment clause could be exercised in January 2013, the situation had changed. With the eurozone clearly on the mend and financial tensions eased, repayments quickly flowed.
At the end of last week €450bn had been repaid. And the ECB’s balance sheet has shrunk significantly: relative to gross domestic product, it will soon be smaller than the US Federal Reserve’s.
Withdrawing all that liquidity has pushed up market interest rates. As a result of cuts in official ECB interest rates, the euro overnight index average (Eonia) – an interest rate benchmark – had crashed almost to zero (excluding spikes caused by technical factors). This week it was back above 35 basis points.
You can argue that LTRO repayments are good news. Banks are repaying ECB money because their finances are healthier and they can borrow again in markets.
Strikingly, a quarter of LTRO repayments have been by banks in Spain, on the eurozone’s crisis hit “periphery”, according to Barclays. “A higher Eonia is a small price to pay for a return of investors to the periphery,” says Laurent Fransolet, the bank’s head of fixed income research.
The rises so far in Eonia are also modest compared with the peaks seen during the crisis years. What is more, repayment of the LTROs – which were the eurozone’s answer to “quantitative easing” – are making easier an eventual exit from the ECB’s exceptionally loose monetary policies.
While the Fed has struggled to calibrate manually the tapering, or scaling back, of its asset purchase programme without creating turmoil in global financial markets, the pace of the ECB’s exit is driven by the market; banks repay ECB funds as their finances improve.
In the long run that might arguably produce better economic outcomes. The snag is that this seems precisely the wrong time for an ECB exit.
While the LTROs were designed to avert a looming bank crisis, the ECB’s task in coming months is to prevent sharp falls in eurozone inflation from turning into a deflationary shock. The slow pace at which the Fed is unwinding its crisis policies has kept the euro high against the dollar, adding to downward pressure on eurozone prices.
Mr Draghi could try to override the automatic tightening effects of LTRO payments, but that may not be easy. Given that banks are repaying LTROs, take-up of any fresh offers of long-term ECB loans might be embarrassingly weak.
The ECB could cut its main policy rate again – already at just 0.25 per cent. Beyond that, the only alternative may be full-blown US-style quantitative easing, an option it has resisted so far.
We are not at that point yet. Mr Draghi points out rightly that there is no clear relationship between measures of “excess liquidity” and Eonia – LTRO repayments are only part of the story. But the ECB is braced for an acceleration in repayments. From this month the maturity of outstanding loans has fallen below a year, making them less useful to banks needing to impress regulators.
The warning lights are flashing in money markets.
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