Saturday, May 15, 2010

Quantitative Easing in Europe - what's the real point?

It seems like the European Bailout package isn't the complete bailout that banks were hoping for. At least, not yet. But that doesn't mean banks have given up trying to make it one.

After the 'almost $1 trillion' bailout package announced on Sunday, pressure is building on the European Central Bank to support it by buying government debt of the peripheral European nations. The ECB has already agreed to buy Greek, Portuguese & Spanish government debt along with private sector debt but, to keep these purchases liquidity neutral, it plans to sell an equal amount of German and French government debt. But the amounts the ECB is willing to commit to this endeavor are relatively small and limited by their holdings of, and ability to sell, German and French debt. In a bid to increase this amount, financial market analysts are trying to get the ECB to delink sales from purchases. The reason being offered, of course, is very different from the real one. Analysts are trying to make the ECB believe that it needs to undertake quantitative easing to 'unfreeze' Europe's slowly freezing credit market. But before we go deeper into the real reason, let's look at some numbers.

The EU has already pledged to set aside over $75 bln to manage balance of payment issues. In addition EU nations will set up a Special Purpose Vehicle (SPV) which will underwrite/guarantee upto $560 bln of weaker members' Government debt. The IMF will contribute close to $320 bln to this effort through either of the channels in addition to the EU commitments bringing the total to a whopping $955 bln.

However, financial analysts will have the world believe that despite the 'ginormous' size, this isn't enough and suggest the ECB step in and buy close to $400 bln of government debt issued by these close-to-failed states as well. To make their 'unfreezing' premise believable and to free these purchases from restrictive limits, they also suggest that the ECB should not sterilize the liquidity. They propose that since this liquidity will go to the banks already holding this government debt, this will allow them to continue functioning normally.

It seems, having analyzed the bailout package, banks and financial institutions have realized that it doesn't give them a way out of their current holdings of debt issued by these weak nations. Debt which matures in the next 3 years will be rolled over with guarantees by the SPV or underwritten by it, but banks have no way out of their holdings of longer term debt issued by these nations.

Analysis of the bailout package also suggests that it will do nothing to stop Greece from defaulting eventually. Similarly, it doesn't really help other peripheral countries like Portugal, Spain etc. This is because the package concentrates it's efforts on improving liquidity for their debt, but doesn't address their solvency. This solvency issue can only be corrected by a partial default, also called debt renegotiation. But, debt renegotiation will involve write-downs in the value of this debt and a direct loss to the holders of this debt.

Worried about these losses, and not knowing which bank will suffer more, banks have virtually stopped lending to each other, preferring instead to deposit funds with the ECB. As of Monday, bank surpluses deposited with the ECB totaled just under $400 bln, the highest since July 2009. This suggests two things.

1) There is no shortage of liquidity with the banks and the demand for additional liquidity is completely unjustified.

2) Banks are seriously concerned about their own solvency if one or more of these countries were to default and don't trust each other to survive. Hence the reluctance to lend.

But in doing so, they are also making it clear that they will continue to hold the financial markets to ransom till their demand to be insulated from these losses is met.

The ECB has called their bluff to some extent by addressing their fear of frozen markets and re-introducing a facility under which it lends to banks for slightly longer periods, similar to what it did in 2007/2008. But this has only changed their argument. There are now suggestions that inflation caused by quantitative easing is desirable as it will allow the fiscally weak nations to recover easily, given that inflation reduces the real value of debt. That rising inflation would go against the only task the ECB has been entrusted with is, of course, of no consequence to these self serving advisors.

Hopefully, it's still of consequence to the ECB.

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