The ECB and Euroland

Given the current positive carry that the ECB enjoys on its lending to Europe’s troubled banks and governments, none of whom have yet defaulted, we can expect that the ECB (or more particularly its member banks) could easily afford to write down some of their holdings of Greek bonds. Indeed, although the ECB only has a notional €80bn of capital and reserves, the cabal of central banks that make up the ECB have a combined revaluation account surplus of close to €400bn, which could in theory easily absorb losses on the ECB’s Greek bonds.

What may be more of a sticking point for the ECB in agreeing to take losses on its Greek debt holdings is the principle: central banks are not supposed to bear credit risk. What’s more if the ECB shoulders a loss on Greek debt, what of the other PIIGS? If a precedent is set, the ECB could face significant losses on the €100bn it holds in bank bonds and €600bn that it holds in sovereign bonds. To be clear, the ECB could afford more losses before it too became financially weakened, but the result of such a policy would be unpopular losses for the national central banks.

Indeed, we already have disquiet in Greece over the Troika plan to assume virtually full control of Greek fiscal policy but there might be German disquiet over any realised Bundesbank losses connected with any Greek debt write-down. Hence, although the markets are expecting (probably correctly) a deal on Greece in the next few days that will involve more loans and a write-down of Greece’s existing debt, out in the real world the Euro has clearly retained its ability to make virtually everyone unhappy at the same time and that can do nothing to improve its fundamental credibility.

While an imminent Greek debt deal may soothe markets in the near term, it will do nothing to solve the fault lines in Euroland, and it may make the system even more unpopular with the average citizen who at the end of the day will decide the project’s future, either through the ballot box or by simply refusing to hold the Euro as a store of value. Meanwhile, governments appear unruffled. This isn’t helpful as the situation is serious and reflects basic imbalances or disequilibria in the system, with significant divergence in underlying competitiveness and economic activity levels.

One consequence is that whilst people in the periphery have relatively high money balances, these have been shifted from domestic bank deposits in a local bank to ‘safer’ assets, such as deposits in Germany, and it is this deposit flight by real world people from the periphery into the core countries that has obliged the ECB to resort to the TARGET2/LTRO banking system support measures, which are designed to shore-up the banking systems that are suffering the deposit outflows.

If the TARGET2/LTRO system was not in place, the peripheral banks would presumably have been obliged to raise the interest rates that they offered their depositors (as indeed the Spanish banks were doing in 2010), so as to staunch the deposit outflows. As a result, we may conclude that the TARGET/LTRO system is actually in some senses preventing a ‘cure’ to the deposit outflow problem> Put simply, it is accommodating rather than curing it.

Moreover, if the peripheral banking systems do in a sense ‘over borrow’ from the ECB and then use the extra funds to acquire domestic sovereign bonds, as seems potentially to be occurring and which the markets hope is occurring, then this will have the effect of implicitly monetising the government debt. In a monetary sense, it makes no difference whether a central bank or a commercial bank buys government bonds as both actions increase ‘broad money supply’ in the country concerned, thereby adding more domestic deposits to a system that notionally already has “too many “domestic deposits.

It is therefore possible that the LTROs may add more domestic money to economies which are already attempting to reduce they holdings of domestic money, and this may therefore increase deposit flight and so place even more strain on the TARGET system.

So although the LTROs and an imminent Greek rescue compromise may appear to be reducing near term tail risks in Euroland, systemic flaws remain. That said, were the ECB to ease proactively, and the euro fell back another 15% or so on the foreign exchanges, this would at least provide more near term support.

James Bevan is chief investment officer of CCLA, specialist fund manager for charities and the public sector. CCLA launched The Public Sector Deposit Fund in 2011 to meet the needs of local authorities and other public sector organisations. You can follow James on twitter @jamesbevan_ccla