ECB balance sheet sucked further into

the crisis
December 21, 2011

Gavyn Davies

The explosion in central bank balance sheets continues. As explained in this earlier
blog, 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 €489 billion 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
€2o0 billion. In addition, the ECB has borrowed a further $28 billion 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 €700-800 billion, 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 €600 billion 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
governments 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.