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Behind the ECB’s smoke-and-mirror show

Published in Business Spectator (Melbourne), 12 June 2014

When the European Central Bank announced its new policy measures last week, most of the commentary focused on the introduction of negative interest rates. From now on, commercial banks depositing funds with the ECB will have to pay a penalty for doing so. Admittedly, this is quite an unusual arrangement. However, it should have been a side story.

While the whole world talked about negative interest rates, the ECB managed to introduce some other policies without creating a big fuss. These other policies show what last week’s intervention was really all about. It had little to do with restoring the fabled monetary transmission mechanism, and everything to do with propping up European banks and governments.

The official story the ECB likes to propagate is, of course, a different one. It goes something like this: Despite already low interest rates, banks had not made enough credit available to businesses, particularly in eurozone periphery countries. At the same time, price level increases had been too far below the 2 per cent target.

To counter both this credit crunch and the threat of deflation, the ECB had to take action, or so it claims. To achieve its goals, it would punish banks for depositing money with the ECB instead of lending it out. It would stop sterilising previous bond purchases, and it would also cut interest rates from 0.25 to 0.15 per cent. A rate cut by 0.1 per cent perhaps does not sound much but maybe the way to think about it is that it means a 40 per cent reduction in interest rates, at least in relative terms.

The most interesting new ECB initiative, however, is another injection of cash into the banking sector. Under the ECB’s new targeted long-term refinancing operation banks can borrow EUR 400 billion at a very favourable interest rate of just 10 basis points above the ECB’s fixed rate. Currently this would be 0.25 per cent.

What allegedly makes this policy ‘targeted’ is the requirement that commercial banks should use the money to lend it on to the private sector (whereas the previous LTRO programs came with no strings attached). This, the ECB argues, would revive the transmission mechanism and ensure that credit once again becomes available to households and firms.

But will it really?

A look at the fine print reveals that the ECB is not too serious about its own policy. If the ECB really wanted to ensure that its newly created money reaches its supposed targets, it would attach severe penalties to those banks that use the funds from the TLTRO scheme for other purposes. But it does not.

The key sentence in the ECB’s media release is this: “Counterparties that have borrowed under the TLTROs and whose net lending to the euro area non-financial private sector, excluding loans to households for house purchase, in the period from May 1 2014 to April 30 2016 is below the benchmark will be required to pay back borrowings in September 2016.”

It may at first sound like a harmless technicality but this one sentence undermines the ECB’s credibility. What it means is this: The banks only have to promise to lend the ECB’s fresh money to the private sector. If they do not, then all they have to do is repay their borrowings after two years (instead of four). There is no penalty for such abuse of ECB funding. Needless to say, the banks will be able to keep all profits they make out of their borrowings.

In practice, then, the ‘targeted’ LTRO program may turn out quite different from what the ECB tried to sell to the public last week. Instead of making risky loans to the private sector, banks could play it safe and invest the ECB’s funds into sovereign bonds from eurozone countries with a maximum maturity of two years. This is safe because these bonds are effectively guaranteed by the ECB’s promise to do “whatever it takes” to save the euro.

The advantages to governments and banks are easy to understand. For eurozone governments, this makes it even easier to refinance, depressing yields on their bonds. It is a wonderful gift to governments particularly in the highly indebted Euro periphery.

The second beneficiary of the ECB’s ‘targeted’ operations are the banks that receive the funds. Their business model is simple. Borrow at 0.25 per cent and then lend on to, say, Italy for 0.6 per cent at two-year maturity. Or even better, invest in Greek bonds with six months’ maturity and a yield above 2.1 per cent. Keep the difference between the two rates, repay the TLTRO funds to the ECB in 2016, and don’t forget to say sorry for misusing the funds.

It is not only cynics that might conclude the ECB’s LTRO program is indeed effectively targeted — just not at the private sector but at banks and governments. Governments get further help in their debt crises, and banks receive a much welcome cash injection prior to the ECB’s much dreaded stress test later this year.

There are good reasons to question the ECB’s rhetoric about restoring the transmission mechanism. It is not even clear whether the decline in lending to the private sector was caused by banks’ reluctance to lend or the private sector’s unwillingness to borrow. As households and companies are deleveraging in the wake of the financial crisis, making extra ECB funds available will make little difference.

The negative interest rate on the ECB’s deposit facility may be eye-catching but will not have a big impact either. Its biggest effect has probably been to detract attention from the ECB’s other measures.

Finally, the combination of the ECB’s unusual and increasingly desperate policies underline that the euro crisis is by no means over. The possibility of an imminent collapse of the eurozone may have gone after the ECB’s de facto guarantee of all eurozone governments’ and banks’ solvency. But the price it has paid for this promise is becoming more and more visible.

What we are seeing now is a continent barely held together by the monetary alchemy of its central bank. But you have to hand it to the ECB: it has developed extraordinary skills in concealing the real nature of its actions. No other central bank could so beautifully camouflage subsidies to banks and governments as help to the private sector.

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