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31 октября 2012, 16:01

OMT: Slouching toward Eurobills?

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The Eurocrisis has many dimensions—bank solvency crisis, sovereign debt crisis, political unity crisis, and economic/unemployment crisis—but time after time it has been the liquidity crisis dimension driving events, and ECB response to the liquidity crisis driving institutional evolution.  The reason is simple.  Liquidity kills you quick.   Most people, probably, think that the real point of Outright Monetary Transactions is to support the price of sovereign debt, notwithstanding Draghi’s claim that it is about fixing a broken monetary transmission mechanism, since low policy rates seem not to be transmitted to low sovereign debt rates.  But maybe Draghi has more of a point than most people realize.  From a money view perspective, let’s consider the possible connection between proposed Outright Monetary Transactions and the ongoing problem of burgeoning Target 2 balances between surplus and deficit national central banks of Europe.     If there were Eurobills, balances could be settled periodically by transfer of assets, just as is done in the Federal Reserve System.   More precisely, if there were a System Open Market Account at the ECB, in which all of the national central banks held shares, settlement could be made by transfer of shares.   From this perspective, OMT can be seen as the first step toward a kind of system open market account, and the shares in that account would be a kind of first step toward a Eurobill.      We know that the Bundesbank is not happy that it has accumulated such large Target 2 balances, which are essentially unsecured claims against the Eurosystem as a whole.  We know also that the Bundesbank would be quite happy receiving German bonds as settlement for those claims, but that is not going to happen and everyone knows it.  So the question is whether Spanish sovereign bills would be acceptable, and it seems that maybe the answer is positive, especially if the sovereign commits to some kind of conditionality before hand.     Even better however if the Bundesbank could receive shares in a system open market account, representing a portfolio of the various assets held by the Eurosystem.  The point is not so much diversification as it is security.  In effect, these shares would be a kind of proto-Eurobill, maybe not yet traded in private money markets, but traded nonetheless in settlement between national central banks.  So maybe we should  be pushing for a package deal, not just Spanish OMT but also others (Italy and maybe also France), in order to begin creating a system open market account at the ECB. (See here for such a proposal).   If it works, OMT holds out the prospect to finally settle the Target 2 overhang.  Start with Spain.  Suppose that Rajoy asks for OMT.  Spanish banks sell Spanish bills to the ECB, use the proceeds to repay loans from their national central bank, which then uses the proceeds to repay Target 2 loans from the Eurosystem.  Hey presto, settlement.     But now the ECB has new Spanish bills as an asset, and new deposits as a liability, and both have to be booked at one of the national central banks.  Book them at the Bundesbank and the deposit liability cancels against the Target 2 repayment, leaving Spanish bills as an asset.  In effect, Target 2 balances are replaced by Spanish bills.  That's why the crux of the matter is whether the Bundesbank commits to accept Spanish bills.   The larger point of this post is the simple observation that the Bundesbank will more readily accept Spanish bills if in some sense these bills are the joint and several liability of all the European sovereignties.   If Spain, Italy, and France all went in for OMT together, and the resulting assets were segregated in a system open market account in which all national central banks held shares, we would be halfway there.   The unsecured liabilities of the Eurosystem, such as Target 2 balances, are already the joint and several liability of the national central banks which capitalize the ECB.  A system open market account in which national central banks hold shares is just a secured version of the same thing.  This is the sense in which Draghi’s OMT offers the prospect of a kind of backdoor Eurobill, essentially a secured clearinghouse certificate now, but possibly something more in the future.  

18 октября 2012, 00:54

Liquidity, Down the Drain

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China released quarterly GDP figures this week. Wen Jiabao emphasized the parts of the release that pointed toward stabilization, and one can certainly find some logic to that view. Stabilized or not, China's target of 7.5% growth marks a steep slowdown over recent growth rates. Other major economies, facing weak demand, currency crisis, and high unemployment, have pushed monetary policy to the hilt with various forms of central-bank balance sheet expansion—QE3 in the US, OMT (announced, not yet used) in the euro zone, and maintenance of a currency peg in Switzerland. What about China? The PBoC has certainly not been sitting still. Earlier this week it lent RMB 30bn ($5bn) to the money market, on the heels of a near-record injection of RMB 265bn ($42bn) into the Chinese money market earlier this month. This has come in the form of reverse repo operations: It is worth remembering what is the immediate effect of such injections on the financial system. In a contracting economy, borrowers are coming up short, unable to meet their maturing obligations as they come due (in China as in any financial capitalist economy). The strain falls onto the banks, who can absorb it when the shortfalls are small. When the shortfalls become too large to be absorbed by any one bank, the biggest bank around, the PBoC, can create new money to meet the strain, which is the economic substance of these short-term liquidity operations. They have been successful in pulling down overnight interest rates, but not at even slightly longer tenors, including the normal measure of Chinese interbank conditions, the seven-day repo rate. The RMB 265bn ($42bn) injection was enough to bring down the seven-day rate by just 3bp. One problem is that the reverse repo operations themselves have a fairly short term, and so they will have to be refinanced or unwound over the next few weeks, depending on whether the PBoC continues accommodation. The context of all of this is the question of whether China will be able to rebalance incomes in its economy away from investment and toward domestic consumption. If the current high level of investment is unsustainable, it will surely come to an end. Coming to an end means, practically speaking, that producers of capital goods (and inputs to those goods) will be coming up short at the end of the month. There is evidence, albeit anecdotal, on this score. In his latest newsletter, Michael Pettis points us to Bloomberg: Copper inventories at bonded warehouses in Shanghai probably climbed to a record as import premiums dropped to a four-month low, signaling demand in China may not be improving as much as expected after a summer lull. Other similar stories can be found. Simply put, as investment spending falls, industrial inputs like copper will go unsold. Inventories will pile up, and producers will find it hard to pay their bills. This will in turn bubble up as unmet obligations and, ultimately, liquidity strains in the banking system. There are two ways out: either chronic shortfalls leading to bankruptcies in the capital-goods sector and contraction of investment, or sufficiently rapid growth of consumption to rebalance the economy without allowing capital-good production to contract. The trouble for the PBoC is that, in the first case, the shortfalls are not going to go away in seven days or even in three months, so liquidity is no help; and in the second case, a major structural change needs to play out, so liquidity is still no help. China has avoided large-scale stimulus in the current cycle, perhaps looking ahead to the Party Congress and leadership change in November. So perhaps the PBoC, not entirely unlike the Fed, feels that monetary policy must be used, even if fiscal policy would be more appropriate under the circumstances. The Fed, the ECB, the SNB, and the PBoC have taken stock, and each has decided that large amounts of liquidity are called for. Rough seas ahead seems a safe prediction.

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03 октября 2012, 21:23

Ring-fencing Explained

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Everyone wants to ring-fence something, but they can’t agree on what:  Vickers, Liikanen, Volcker. In all proposals, the idea is to have bank capital separately allocated for some activity, and to prevent that capital from being exposed to any other activity.  Some people want to lock the wild animals in a cage to keep them away from us; some people want to lock the tame animals in a cage to keep them safe from the dangerous world outside. Vickers wants to ringfence retail banking, with the idea of trying to protect Main Street from the other more risky activities of banks.  Liikanen wants to ringfence all trading activities (i.e. Wall Street), apparently in the hope of keeping the rest of the bank safe from them.  And Volcker wants simply to ring fence the market-making aspect of trading, in order to separate it from so-called proprietary trading which exposes bank capital to price risk. All three proposals represent attempts to come to regulatory grips with the dramatic changes in the nature of banking over the last 30 years or so, changes that were revealed to the world by the global financial crisis that began in August 2007 and continues to this day. My own view is that we need to begin by thinking of banking more generally as dealing, and distinguish between money dealers who quote buy and sell prices for funds, and risk dealers who quote buy and sell prices for risk.   I think both of these activities need backstop, not just the money dealers, but different kinds of backstop since funding liquidity is a different thing from market liquidity. Further, in both cases, we need to distinguish between matched-book dealing and speculative dealing.  That’s essentially what Volcker is trying to do, but probably I get to this view from a different chain of logic.  The ideal of matched book is to have offsetting risk exposures that exactly net out; if you could really do this, you would not need any capital since you would be bearing no risk.  But there is one kind of risk that does not net out, and that is liquidity risk which is systemic.  The larger the scale of the matched book position, the larger the liquidity risk, even if all other risks net out.   Because of this, there is always an implicit liquidity put from matched book dealers, both money dealers and risk dealers, to the central bank.  My view is that we should make that liquidity put explicit, and then argue about the details, including how much it should cost. Speculative dealing is an entirely different animal, at least conceptually.  It is true that liquidity risk is involved, again in both money and risk dealing, but price risk is the big thing, so this is where you want there to be capital requirements, or other ways of ensuring that the taxpayer is not providing implicit capitalization.  Where does that leave me in terms of the proposals on the table? I don’t think it makes sense to try to ring fence either Main Street or Wall Street.  Shadow banking brought them together—money market funding of capital market borrowing—and the collapse of shadow banking has torn them apart.  We could of course simply adopt a regulatory structure that reads that experience as the verdict of history, and so strives to keep the two sides apart forever more.  My concern is that maybe that is just piling on, rather than constructively trying to imagine an ongoing engagement between the two, a market based credit system that is shorn of the worst elements of the shadow banking system. Europe is having its Glass-Steagall moment, and maybe they just have to go through it.  But the US has been there and done that.  I’m with Volcker that we need to try to distinguish matched-book market making from speculative position taking.   The former involves liquidity risk, and requires liquidity backstop, which should be forthcoming.  (Maybe we should actively try to concentrate it at central clearing counterparties?)  The latter involves price risk, and requires capital backstop, which should be demanded by counterparties in the first place, and by regulators protecting the public purse in the second place.