By Stephen Lewis, Chief Economist, Monument Securities
The euro has performed strongly so far this year. Since 31 December, its effective rate has risen by more than 2% to stand at its highest since November 2011. It is back at the level it traded immediately prior to the ECB’s announcing it would extend liquidity to banks through 3-year long-term refinancing operations (LTROs). It was on 8 December 2011 that Mr Draghi presented the ECB’s plan to conduct much longer-term refinancing operations than it had previously undertaken, with allotments taking place on 21 December of that year and, as was subsequently determined, on 29 February 2012. It later emerged that this decision had been taken because the ECB was deeply concerned that a serious shortage of liquidity in the euro zone banking system, if not relieved, might precipitate a financial crisis. We may recall that the December LTRO attracted €489bn of bids from the banks, while the February exercise supplied an extra €529bn of liquidity. With this access of funds, the demand for euro liquidity that had been helping to underpin the single currency’s exchange rate subsided, to be replaced in some parts of the system with surplus euro balances. Thus, banks’ deposits with the ECB, that is, surplus funds they left with the central bank, rose from €707bn on 2 December 2011 to €1,149bn by 2 March 2012. They were still up at €940bn in the latest statement week, to 11 January this year. When the LTROs were introduced, there was provision for banks to repay their borrowings from the ECB early, if they so chose. For the December 2011 LTRO, the earliest possible repayment date was 30 January this year, while for the February 2012 operation banks could repay from 27 February 2013. After these initial repayment dates, banks may pay back early on any day of the ECB’s weekly refinancing operations. The euro zone money markets are increasingly apprehensive as they approach the early repayment dates. They have little idea how many banks will unwind the LTROs, or on what scale they will do so. Furthermore, they are not sure how, or whether, LTRO repayments will affect market levels.
At first glance, it may seem unlikely that any banks would be inclined to return funds to the ECB when the market supply of liquidity is uncertain and when the authorities are concerned that banks should maintain larger holdings of liquid assets than in the past. However, the ECB funds come at a cost, the central bank’s 0.75% minimum refinancing rate. If banks cannot find assets that yield more than that, their LTRO participation incurs a loss. The banks that are holding deposits at the ECB are earning nothing on that part of their portfolio. If such deposits are financed by funds raised through LTROs, there may be a strong profit motive to unwind the LTROs by running down the deposits. Some banks may only have participated in the LTROs in the first place because national authorities were leaning on them to do so, to minimise the stigma for participating banks that really needed the extra liquidity. As with the TARP operations in the USA, such banks may be eager to exit as quickly as possible, though the authorities may reflect that the banks that feel unable to repay might still suffer a loss of credibility. The authorities could, therefore, see good reason to discourage early repayment. However, since systemic risks now seem less serious than when banks were bidding for LTRO funds, the authorities’ argument might be less persuasive now than it was then.
Some banks have profited hugely from participating in the LTROs. These are the banks in the euro zone’s periphery that used funds from the ECB to buy sovereign bonds in their domestic markets. They now have hard decisions to make. After the massive gains they have racked up on their bond purchases, they have to judge whether there is more bond appreciation to come or if they should take profits while they can. If they follow the latter course, they could be in a position to unwind some at least of their LTROs. The implications for peripheral bond markets would clearly be negative. The judgment is not a simple one because each bank will have to consider how other banks are likely to behave. Further, the ECB’s Outright Monetary Transactions (OMT) facility provides a backstop for peripheral bond markets, but only if it is activated. OMT operations are only likely to occur after significant negative pressures have already been felt, and losses from current levels suffered, by bondholders. Banks in the periphery may, in any case, choose to unwind part of last year’s LTRO-based transactions to prove to the world at large their confidence that other sources of funding than the ECB are now open to them.
The markets’ deepest concern is that banks will try to raise funds in money markets in order to repay LTRO funds. Market participants are anxious this could drive up money market interest rates, counter to the ECB’s policy intentions. If this were to happen, though, it would be open to the ECB to react by cutting its official interest rates. There would then merely be a change in the spread between official and market rates, with market rates gravitating back to levels at which they stood prior to the LTRO repayment. Since the ECB aims to maintain accommodative monetary conditions, it may well be expected to take such action on its own lending rates, if the need arises. The three-month euribor rate, with a maturity that spans the initial repayment dates of both 3-year LTROs, has edged up by 2 basis points since the start of this year, while corresponding sterling and US dollar rates have been unchanged. The liquidity concerns reflected in the rise in the euribor rates have been offset, to some extent, by the consideration that heavy LTRO repayments would at least show banks were confident in their ability to raise funds; the upward pressure on the risk-free EONIA has been even more intense. However, Mr Coeuré’s comments on euro zone liquidity appear, at least temporarily, to have calmed market fears. In any case, if the repayments do undermine the euro exchange rate, bond market disturbances seem a more likely cause than money market developments.