Central bank intervention, liquidity provision and European deleveraging

Over the last few weeks credit markets have been less focused on fear of systemic risk, instead continuing the move back towards a more normal environment, focused on economies’ underlying fundamentals. For example, there has been more dollar strength in the light of the improving fundamental realities in the US, and more Euro weakness on the back of worse than expected Euroland PMIs. This provides for a much more rational and healthy investment environment. Asset prices as a result have continued to increase, although Europe is not yet out of the woods.

The two doses of LTRO are having a positive influence, having bought Europe’s banking systems time (for France and the Netherlands in particular) at a point when it looked increasingly likely that peripheral European stresses might spread to the larger economies, causing a contagious feedback look that potentially would have brought about the disintegration of the European system. By providing unlimited funding against collateral of decreasing quality the ECB has effectively allowed a bailout for the European sovereigns via their banking systems. As such the LTRO has allowed the ECB to stick to the generic central bank mandate of being a lender of last resort to the banking systems, whilst at the same time effectively doing the same role for the sovereigns.

Whilst weaker banks have used the LTRO to increase their holdings of European sovereign debt which has helped underpin the yields of the respective countries, if we continue to see fundamentals in Euroland decline, we are likely to see these increased holdings on banks’ balance sheets become a source of potential volatility and worry.

As a connected point, provision of unlimited funding to the banks buys time for the political leaders to put their houses in order but it doesn’t solve the underlying problems of too little growth in Euroland (and no real focus on creating it) and too much debt. In terms of growth it is widely anticipated that Euroland will remain in a state of contraction throughout 2012, with the growth rate primarily dragged down by peripheral economies and austerity measures.

Against this backcloth, the Euroland central banks’ balance sheet now stands at around 33% of Euroland GDP, with the debt crisis moving from individuals to banks to sovereigns, and finally central banks.

It is expected that transparent, explicit and solid firewalls need to be put in place to ensure that the LTRO-led liquidity provision is turned into a true back stop for the weakest nations. This will prevent contagion to the solvent core countries from the more vulnerable periphery. Politicians need a high degree of coordination and a clear move to a deeper fiscal union to regain credibility. For now, the spread between Spanish and Italian yields continues to tick wider with low confidence on Euroland’s ability to deal with an increasingly unstable situation in Spain.

Debt reduction is only one part of a lasting solution and ultimately growth is the only solid path out of the current crisis. LTRO-inspired asset price inflation does provide a feel good factor for markets which may continue into Q2, but politicians need to adopt initiatives that could potentially support growth, such as labour market reform. Governments also need to go further to fix the broken transmission mechanisms that allow stimulus to feed through to SMEs and individuals, which in turn will set in motion a positive feedback loop which allows business to regain confidence to invest and individuals confidence to spend and consume the output. They also need to go further in encouraging labour and capital mobility to enable a more efficient allocation of resources across Euroland. Until efforts are stepped up in these areas it’s increasingly difficult to see austerity measures leading to longer-term growth.

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