Thursday, September 06, 2012

Mr. Draghi Is Sterilizing His Purchases, What Could Possibly Go Wrong?

6 September 2012

This post is being entered quickly, so it is for "those in the know." If You don't understand what Mr. Draghi just did (explanation here), then this post will not be much help to you.

My thoughts on Mr. Draghi's plans to buy the debt of troubled Euro nations and "sterilize" it by selling the central bank's best-quality assets follow (originally posted here):

Obviously Mr. Draghi will do unsterilized sovereign bond buying at some point. Even with supervision, the PIIGS will be badly behaved. But I don't think he can just print right away.

On the upside (for him), he doesn't have to raise German cash or sell German debt IF he prints new Euros and buys the sovereign debt of the PIIGS without obtaining "real" money from the better-off EMU members. It seems to be a process. The original rules under which the Euro was constructed are going out the window, one by one. It seems only the Germans have a long memory. However, the EMU had, until recently, been a win-win game for all the players. Greece got to pretend there is no tomorrow. Germany boosted exports. France got to play both sides.

Now, the only course of action that will keep the win-win equation going a little while longer will be unsterilized purchases of "junk" government debt. If the junk is bought with printed money, then it is nobody's (and everybody's) obligation. What could be the downside? Apart from the certainty of ultimate currency collapse, it's looking pretty cheery out there.... Currency destruction is obviously a problem for another day.

With new Euros, China benefits, etc., etc. It's all a big, globally connected, spinning wheel (until the wheel comes off the cart). But let's deal with that chapter when we get there. Certainly the precious metal market is having no trouble figuring it out. The gold buyers are voting with their feet. So why don't the Germans just buy gold? Everybody's happy, and Germany still wins.

8 September 2012: OK. More information is in. The plan is to encourage deposits at ultra-low interest rates, and thus take money out of circulation in exchange for the purchases of "junk" sovereign bonds of no more than 3 years' duration (the shorter term chosen presumably to reduce risk).

Hmmm. Exactly why would this work? The take-away is that the junk is going to get bought to keep the Euro currency wheel spinning a while longer, perhaps much longer. But, exactly how is this ever going to play out over the medium to long-term? Why would I, or any entity, wish to give the ECB my hard-earned cash on deposit, knowing that the central bank is decimating its asset base with the worthless government bonds of profligate Eurozone nations? This does not add up on so many levels!

Here is the current situation and its implications, according to the WSJ. Interestingly, business confidence is so low at this time, it's easy right now to get partners to park cash with the ECB for vanishingly low interest:

In principle, “sterilization” is a process that ensures that individual actions by the central bank don’t result in an overall increase in the money supply. Monetarist theory dictates, after all, that it is excessive monetary growth that leads to inflation, which is what the ECB is exclusively mandated to guard against.

Every week since it started buying bonds under its old Securities Markets Program, the ECB has withdrawn from circulation an amount of money equivalent to what it had spent so far in buying them. For the last six months, this figure has hovered around €210 billion. The amount falls as the bonds it holds mature.

It has done this by offering one-week deposits to the banking system. Banks bid competitively for the deposits, and the rate bid has tracked the ECB’s own overnight deposit rate very closely. It has been only fractionally above zero since the ECB last cut its deposit rate in July.

Fears that it would prove difficult for the ECB to sterilize such a large amount of money regularly have so far been unfounded. On the few occasions when it has failed to auction the full amount of deposits, it has been due to exceptional, technical factors in the money market which have never lasted beyond a day or two.

This situation might change if the ECB and the euro zone succeed in restoring so much confidence to the region’s financial markets and economy that banks start again to lend to each other, and to businesses and households. Before the crisis, the private sector routinely created a multiple of the money created by the central bank.

But the link between central bank money and privately created money has changed beyond recognition since 2007. Growth in broad money aggregates has collapsed despite the ECB more than doubling the size of the monetary base, which typically consists of cash in circulation plus banks’ reserves at the central bank.

As of today, the precautionary hoarding of reserves by euro-zone banks is so great that banks are holding over €770 billion in excess reserves in accounts at the ECB, voluntarily “sterilizing” money the ECB created without forcing it to lift a finger.

The ECB is sterilizing another €209 billion by paying only 0.01% on the deposits it auctions. In the current environment, it does not seem like the ECB would struggle to withdraw from the market any amount of liquidity it wanted to. Even so, the numbers implicit in the ECB’s new bond-buying scheme are daunting. Excluding treasury bills, there are some €390 billion in Italian bonds that fall due in the next three years.

For Spain, the number is €203 billion, for Portugal and Ireland combined, another €50 billion, according to national debt agency data. In all, a total of over €640 billion. Of this, it seems likely that the ECB already holds — and sterilizes — a large part of its €209 billion SMP portfolio. There are no precise data yet on the ECB’s holdings, but only around 40 billion euros is accounted for by Greece.

Thus the amount that the ECB needs to sterilize could easily double or treble from its current level. This may incline it to sterilize more over a longer time-frame of a month or three months or even more, so as to reduce the potential for volatility in the money market. The ECB has already examined such options internally two years ago, but chose not to proceed.


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