The downgrade of French debt and eight other eurozone sovereigns by Standard & Poor’s has grabbed headlines but the decision of the European Central Bank in December to engage in large-scale, three-year, longer-term refinancing operations (LTROs) is probably more important for markets, marking a distinct new phase in the euro crisis.
The financial crisis in Europe has three principal components: excess debt in the household and corporate sectors of several member countries, excess debt at the national level and a liquidity crisis among banks that could develop into a solvency crisis. The ECB’s actions in December do not address the first two areas, only the banking crisis.
A key feature of eurozone banks’ balance sheets is they have built up a book of loans and securities that is heavily dependent on non-deposit financing – borrowing in the wholesale short-term money markets and by long-term debt issuance.
It is this area of bank finan-cing the ECB has addressed. By agreeing to take a wider range and lower quality of collateral in exchange for three-year funding, the ECB has effectively removed a substantial portion of the anxiety that prevailed in the short-term money markets.
This is why the Italian yield curve has shifted in the past two weeks from inverted to positive at the short end but note that 10-year Italian government bond yields have remained elevated. Banks no longer have to rely as much as previously on other financial institutions to fund or re-finance these borrowings.
In effect, a substantial part of the interbank funding market has been moved on to the ECB’s balance sheet. So far so good. Does the three-year LTRO amount to quantitative easing?
A central bank has three methods of easing monetary conditions and expanding its balance sheet: purchases of foreign currencies, purchases of government or private sector securities, or loans to the government or to commercial banks. Whether or not one calls these operations QE is largely semantics.
The important point is that large-scale purchases or loans – in this case three-year loans amounting to €497bn – tend to lower market interest rates and embolden commercial banks to lend more.
Over the past three years under Jean-Claude Trichet, the ECB’s one-year LTROs and its purchases of government bonds were always fully sterilised – or offset – by corresponding withdrawals of funds elsewhere in the system. On this occasion, under Mario Draghi, that has not happened – so far.
Total lending to euro area banks since the introduction of the three-year LTRO has declined by only €43bn, from €879bn on December 26 to €836bn on January 16.
However, the ECB’s three-year LTRO does not take care of all aspects of the crisis by any means. It does not cure the problem of over-indebted households or the that of struggling real estate developers in Spain, Portugal and Ireland. Neither does it solve the issue of the over-indebted sovereigns such as Greece or Italy. All these still need to curtail expenditure and repair balance sheets.
What the ECB’s LTRO does is enable the banks to fund themselves so they are not forced into immediate insolvency and are not forced to liquidate loans or securities at steep losses. But the banks still have much to do.
First, they need to raise capital. The European Banking Authority conducted stress tests in November and has demanded that banks raise €115bn by June 2012 to bolster balance sheets.
Second, eurozone banks will almost certainly try to reduce the size of their existing portfolios of loans and securities to raise their capital ratios still further.
In contrast to US and UK banks, which reduced their lending and interbank funding in the wake of the Lehman crisis, eurozone banks did neither. Now it is Europe’s turn to face a credit squeeze.
I expect the euro to weaken further and credit to remain tight, intensifying the euro area recession.
John Greenwood is chief economist at Invesco