The circular logic of ECB cash

FT.com

According to reports from Davos, the consensus among global economic leaders is that the most dangerous phase of the eurozone crisis may now be over. Mario Draghi has emerged as the hero of the hour. By using the central bank balance sheet aggressively to stem the credit crunch, the ECB president has dampened bankruptcy fears in the financial system, and talk of "another Lehman” has died down. But while market fear is on the wane, greed has not yet taken over, and that leaves much work for the central bank to do.

It is striking that financial markets have become much more forgiving of bad news from the eurozone since the ECB acted in December. This week's problems in Greece and Portugal have not caused the contagion which would have happened last year.

Furthermore, there are signs that greater confidence in the financial system has already spilled over to the real economy. The PMI and IFO business surveys which were published last week were considerably more upbeat than expected, and they have triggered the first upgrades to eurozone growth forecasts seen for many a long day.

Eurozone real GDP declined at an annual rate of about 1.2 per cent in 2011 Q4, and GDP was widely expected to fall much faster in 2012 Q1 as the economy tumbled into an official recession. However, business survey data are now suggesting that GDP might be approximately flat in Q1, with German data once again looking particularly buoyant.

So is the eurozone now back to "business as usual”? Only a wide eyed optimist would believe that. The money supply data for December, published by the ECB on Friday, were extremely worrying. They showed a financial system moving rapidly into a major episode of deleveraging, with bank deposits and bank lending both entering freefall.

It has long been a puzzle why there has not been a more severe run on bank deposits in the troubled economies during the crisis, since a break up of the euro would almost certainly involve a revaluation of bank deposits in Germany relative to those elsewhere. December's money supply data suggest that this may have finally started to happen.

Bank deposits, presumably in the weak economies, fell by €25 billion in the month. This may have forced banks to reduce their loan books to households and companies, which dropped by €47 billion in December alone. If these trends were to continue, they would be truly ominous, not just for economic activity in the eurozone, but also for activity in many emerging countries, which are heavily dependent on credit from European based banks.

What the ECB has essentially done with its €489 billion liquidity injection in December is to replace the private interbank market which would normally operate if there were a shift in bank deposits from (say) Italy to Germany. These flows would normally be offset by temporary loans from German banks to Italian banks in the interbank market, and the health of the overall economy would be largely unaffected. Now, however, the German banks are unwilling to make these loans, so the ECB has been forced to step in.

As President Draghi explained last week, there has been a vast increase in ECB lending to the banking sector, and a similar increase in bankers' deposits at the ECB. But that does not indicate that the same banks are borrowing money and then holding extra central bank liquidity, which is what many economists had been assuming. What has actually happened is that troubled banks have been borrowing from the ECB, while stronger banks have been building their deposits at the central bank. In effect, the ECB has become the market.

That is all very well, and indeed all very essential, in the short term. But it does emphasise the extent of the credit risk which the ECB is now taking. It is lending to banks which have little or no equity cushion left in their balance sheets if they should eventually fail. And the collateral which the ECB is receiving as part of the trade is largely in the form of sovereign debt which could also default if things go wrong. I am not sure how the ECB has managed to convince itself that this does not amount to lending to governments, which would be in breach of their treaty obligations, but that is what they have done.

Ironically, the potential problem for the ECB's balance sheet is being highlighted by this week's debate on whether the central bank should take a haircut on its holdings of Greek debt, which reportedly amount to over €40 billion, or about half of the central bank's capital base. These holdings were originally acquired in exactly the same way that the ECB is now acquiring Italian and Spanish debt, except on a vastly greater scale. Of course, everyone says that Greece is an entirely separate case, which has no implications whatsoever for what might happen in other cases. The ECB is making a very large bet that this will prove to be the case.

In the near term, the key question for the markets is whether the ECB will maintain and expand its liquidity operations as necessary to prevent a devastating meltdown in the balance sheets of the banks in the troubled economies. Having got this far, I assume that the answer to this question is "yes”. There is no other game in town.

In the longer term, markets are driven by greed as well as fear. Fear has been on the wane, but greed has not yet taken hold. If and when it does, the high returns on offer to investors who are willing to assume sovereign and banking risk in the weak economies may eventually start to attract the private capital flows which are needed to finance the deficits of these countries.

That would be a much greater sign that the financial system is ready to survive without a life support operation from its central bank. We are not there yet.

Copyright The Financial Times Limited 2012