The explosion in central bank balance sheets continues. As explained in this earlier blog, the ECB, the Fed and others have become the holders of last resort for much of the private sector risk which no-one else is willing to touch. Today’s announcement of a record liquidity injection by the ECB, along with a further rise in the Fed’s balance sheet as part of the dollar swap programme, looks particularly dramatic, but it really just represents a continuation of a process which has been underway for many months now.
Whatever they may claim to the contrary, the ECB is finding that it has no choice but to use the central bank balance sheet to stabilise the euro crisis. I am not complaining about that. The alternative would have been far, far worse. But we should call a spade a spade. This is quantitative easing on a significant scale, and the lines between this form of QE, and the direct monetisation of budget deficits, which is forbidden by the spirit of the eurozone treaties, are becoming increasingly blurred.
The scale of today’s ECB operation is very large, but not as large as the headline figures suggest. In gross terms, the central bank has injected €489bn into the banking sector for a three year period, in exchange for collateral of an increasingly dubious nature. However, allowing for the fact that some previous liquidity operations will roll off at the same time, the net increase in the ECB’s balance sheet may be “only” around €2o0bn. In addition, the ECB has borrowed a further $28bn from the Fed this week under the dollar swap programme, and has lent this to eurozone banks.
The graph shows my latest estimate of the size of the ECB’s balance sheet by mid February. The increase from August to February will be about €700-800bn, which is an extraordinary amount for a central bank which is supposed not to believe in QE. There is another three year liquidity injection due to take place in February, and this may well be even larger than today’s action.
The bulk of the borrowers under these facilities will presumably come from the peripheral economies, and the collateral offered will include single A asset-backed securities and also bank loan portfolios for the first time. Although this collateral will of course have been subject to haircuts before being accepted by the ECB, there can be no doubt that the ECB’s potential exposure to defaults in the peripheral economies will once again have ratcheted higher.
The ECB’s justification for this action is that it is, and should be, the lender of last resort to the eurozone banking system. That seem fair enough. In the absence of today’s action, there would have been risks of bank failures in 2012 as banks tried to raise the money needed to redeem €600bn of their own debt, which reaches maturity during the year. With their access to long term funding largely closed, banks would have been forced to reduce their balance sheets in order to meet these obligations, and this deleveraging would have involved forced sales of sovereign bond holdings and reductions in bank lending. Either way, the eurozone’s crisis would have deteriorated further.
Deleveraging would also have caused a shrinkage in broad money (M3) which the ECB is desperate to prevent or mitigate. What will now happen instead is that the monetary base will expand rapidly as central bank funding for the banking sector replaces private funding, and this is likely to prevent the large drop in M3 which would otherwise have occurred.
Questions will be asked, especially in Germany, about whether this liquidity injection will be inflationary. It is probably better described as anti-deflationary. The money multiplier in the eurozone economy (ie M3 divided by the monetary base) is likely to drop, so M3 will stay subdued. Inflation risks will not crystallise until the rise in base money translates into much more buoyancy in bank lending and broad money growth. That may or may not ever happen.
Still, there are serious disadvantages attached to today’s ECB action, however necessary it might have appeared to the Governing Council.
First, the free market for bank funding is becoming increasingly moribund, so normal market disciplines on bank behaviour will cease to operate. And zombie banks, unable to make healthy new loans, will be kept alive, as they were in Japan in the 1990s.
Second, the potential need to recapitalise the ECB’s balance sheet after any debt defaults within the eurozone, or departures of countries from the eurozone, has increased further. This is a contingent liability for the ECB’s equity owners, led by Germany.
Third, the credibility of the “line in the sand” which the ECB has drawn between monetising government budget deficits, and acting as a lender of last resort to banks, will come under increased scrutiny.
The French government was very explicit that the liquidity injection could be used by banks to buy sovereign debt with a large positive carry. This will almost certainly prove too optimistic, since the banks need the money to redeem their own bonds, not to buy risky debt from sovereigns. Nevertheless, the ECB is certainly preventing banks from selling sovereign debt that they otherwise would have sold, and it is doing this by expanding its own balance sheet. The alternative to ECB action would have been to increase the size of the EFSF/ESM at a direct cost to government credit ratings. The ECB is also keeping alive banks which would otherwise have failed, and that would have involved new injections of capital from sovereign governments.
The truth is that, in the present state of the eurozone debt crisis, sovereigns and banks are now inextricably interlinked. It is hard to save one without being accused of saving the other. The ECB is not eager to admit it, but it is trying to save both.