Please, click here to read this article in pdf format: may-13-2010

Perhaps it is very early to tell what will unfold in terms of monetary policy in Europe. Nevertheless we can’t afford to wait for more definitions by policy makers. We are forced therefore to examine two main paths the European Central Bank (ECB) may take in the weeks ahead.
On Monday, M. Trichet repeatedly noted that the ECB was going to purchase PIGS debt in the secondary market, but with sterilization. This means that as the ECB buys these assets, it needs to either sell other assets or issue debt, to withdraw the Euros it printed in the first place, for the purchases.
We looked for official statements indicating what assets could be sold, in exchange of PIGS debt. But we were not successful. However, there has been a rumor since Monday that the sterilizing assets, the assets that will be sold, could be German Bunds. We will take this as a possibility, but we give it a low likelihood. But it is important to examine this scenario and draw conclusions, to gain perspective on what is possible and what is not.
Another way to sterilize the purchases of PIGS debt would be to “issue” short-term debt (i.e. Liabilities to Euro-zone financial institutions). With this, the ECB ends up changing the composition of its liabilities, returning one of its components, the amount of Euros outstanding to its initial level (i.e. the level before the PIGS debt purchases began). The other component would be short-term ECB debt. Let’s examine both scenarios:

Scenario 1: ECB sterilizes PIGS debt purchases selling German Bunds (low probability)
Figure 1

In Fig. 1 above, we see two balance sheets, one for the ECB and one for Euro-zone banks.  For simplicity and illustrative purpose, we included a few main categories in both of them (i.e. Gold, loans, FX reserves, Bunds and PIGS debt).
The purchases of PIGS debt take place in step 2. The ECB debits Euros and credits PIGS debt, while the Euros-zone banks credit Euros and debit PIGS debt. As you can see, on the asset side of the ECB’s balance sheet, PIGS debt increases, matched by an increase in the amount of Euros outstanding (liabilities). The ECB buys this debt from Euro-zone banks, which see a change in the composition of their assets: Higher amount of Euros (liquidity) and lower amount of PIGS debt. As the purchases take place, the supply of PIGS debt decreases, lifting its price, lowering its yield (seen in graph to the right).

Sterilization takes place in step 3. Here, the ECB sells Bunds to the Euro-zone banks, which pay with Euros. The ECB debits Bunds and credits Euros. The Euro-zone banks credit Bunds and debit Euros. At the end of this exercise, the composition of the asset side of the ECB has changed: It has the original amounts of Euros (i.e. prior to the transactions), a lower amount of Bunds and a higher amount of PIGS debt. On the Euro-zone banks side, the asset side composition has also changed. The banks have the same amount of Euros, prior to the beginning of the exercise, but a higher amount of Bunds and a lower amount of PIGS debt. A transfer of risk has taken place, from the Euro-zone banks to the ECB. However, this was not for free. In the process, as shown on the chart to the right on step 3, the supply of Bunds has increased, and so has its yield. The yield of the Bunds is the benchmark rate, the Euro “risk free” rate. This scenario therefore, is recessionary, because it makes borrowing more expensive. It crowds out the private sector.

A few more observations have merit here:

1.-The quantity of Euros remains unchanged, but before the transaction, they were backed by a higher amount of Bunds. Now the Euros are backed by a higher amount of PIGS debt, a riskier credit. Should the “value” of the Euros remain unchanged too? If you got the opportunity to choose, which balance sheet do you prefer, as a holder of Euros? The one in step 1 or the one in step 3? Do depositors in Euros need to be aware of this? No, not if this was a once-and-for-all transaction. But, what if this is carried out indefinitely?

2.- As the Bunds are the Benchmark rate, and the benchmark rate increases when we get to step 3, the transaction is “recessive”. We cynically asked on our last letter (www.sibileau.com/martin/2010/05/10 ) why the market would pay more for Bunds, when one could get a better yield for same risk. Well, it turns out that sometimes reality trumps fiction. The chart below (source: Bloomberg) shows the spread between Greece’s 5-yr credit default swaps (long) and Germany’s 5-yr credit default swap. We were not wrong with our contrarian view. You can see at the far right, how dramatically the spread/risk on Bunds has increased since this Monday, while the gap between Greek and German risk is decreasing.

3.-From points 1 and 2, we realize that sterilizing with Bunds generates recession, hurts growth and deteriorates the value of the Euro. The Euro will drop vs. gold and other currencies. If this is the case, we see a very low likelihood for this scenario.

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Scenario 2: ECB sterilizes PIGS debt purchases issuing short-term debt (Likely)
Figure 2

Figure 2 above shows the same steps 1 & 2 as in Figure 1. The difference here is in the sterilization process. Instead of selling Bunds, in Figure 2 we see the ECB selling short term debt.
Here, the ECB sells short-term paper to the Euro-zone banks. The ECB therefore credits Euros and the Euro-zone banks credit ECB debt. Effectively, the ECB has changed the composition of its liabilities, leaving the same amount of Euros outstanding prior to the transaction, in exchange for a higher amount of PIGS debt on the asset side of its balance sheet. The banks have also changed the composition of the asset side of their balance sheets. The hold the same amount of Euros, but lower PIGS debt and higher ECB debt.

From this, we can draw the following observations:

1.-The quantity of Euros remains unchanged, but are the deposits of the Euro-zone safer by being now partly backed with ECB debt? Hardly, but this question has to be answered in relative terms. For how long will this persist? If the PIGS sovereigns cannot generate a consolidated net fiscal surplus, and they continue to issue debt, the component of ECB debt backing deposits at the Euro-zone banks will increase, vs. other assets, like Euros or Bunds.

2.-We think this sterilization, at best is benchmark-rate neutral, which means that it should not decrease real interest rates. As the amount of ECB issued increases, its price has to decrease/yield has to increase, as shown in the chart to the right, on step 3. We are not familiar with the European rates markets, but with increasing issuance of ECB debt, the spread between Bunds and this debt will be impacted. How this impact will affect corporate borrowing in Europe is still something we have to work on.

What is the exit strategy under Scenario 2?
We would like now to compare this exercise with the Fed’s purchase of US Treasuries, in 2009. We, at “A View from the Trenches” were perhaps one of the first to emphasize how bullish of risky assets this program was, while others (i.e. David Rosenberg, Paul Krugman) kept telling us it would lead nowhere. (refer our very first letter, on April 14th, 2009: www.sibileau.com/martin/2009/04/14 ).

There are two fundamental, structural, institutional differences between the Fed’s program and scenarios 1 or 2.

a)    The Fed bought federal debt, benchmark debt and in so doing, lowered the benchmark rate. The ECB will not buy a federal debt because there is no such a thing under the current European Union and will not buy benchmark debt, which are the German Bunds. Therefore, how can this program be accommodative? This issue underscores the institutional weakness of the European Union, namely the lack of a unified bond market. What the ECB seeks to do here would be similar to a central bank selling Texas’ debt to buy California’s debt or issuing its own debt, with the implicit guarantee of all the US states, to buy California’s debt.

What could the ECB have done differently?
A similar solution to that of the Fed in 2009 would have consisted in having the ECB buy German Bunds without sterilization, from a trust, administered by the Germans, to fund the trust’s purchase of PIGS debt. In exchange, the PIGS sovereign would have had to ring-fence a cash flow stream to repay the trust. This is similar to what takes place in federal unions, where the federal government collects through federal taxes or alternatively, through specific royalties established with provinces or states. With this structure, the ECB would have been able to carry out an accommodative policy, with specific amounts and repayment sources.

b)    The Fed bought a predetermined amount ($300BN), with a predetermined timeline (until Oct. 2009). With the ECB’s plan, the market ignores both the final amount of PIGS debt in the asset side of the ECB’s balance sheet, its composition itself (i.e. how much from Greece? From Spain?) and nobody knows when it will end.

As can be easily concluded, under scenario 2, there cannot be an exit strategy. The ECB has its hands tied and eventually depends on the PIGS sovereign to generate a consolidated fiscal surplus to buyback their debt. Therefore, a reputational issue threatens the European financial system:

a)    What if the so-called “short-term” ECB debt backing deposits is indefinitely rolled over and depositors see the risk and decide not to renew deposits?

b)    If the ECB becomes a riskier bank, its currency will (actually is) no longer be considered an alternative reserve asset and the propensity to exchange it for gold or USDs will increase exponentially. If so, what was the wisdom behind Sunday’s decision by the central banks of the USA , Canada , UK , Switzerland and Japan to provide currency swaps to the ECB? Are currency swaps all of a sudden a “free lunch”? What for were the balance sheets of these institutions compromised? Who pays for it? Should the senior management of those central banks not be audited for decisions of this sort? Who is accountable?

This analysis suggests there could be a generalized run against the Euro as a currency. The Argentinean experience of 2001 offers a analogous case. Back then and there, the central bank did not increase the amount of pesos outstanding. It simply changed the quality of the assets backing those pesos, from USDs (i.e. FX reserves) to government bonds. Argentina did not have inflation. Nevertheless, eventually as in scenario 2, depositors realized that their deposits were not backed by the assets they had expected and decided to rush for the exit door.

Figure 3 below shows the spiraling nature of this process:

Another aspect here is that as this process takes place, the credit quality of the loans held in the Euro-zone banks would quickly deteriorate, further weakening the ECB position.

Would this lead the world to the end of paper money?
We have written many times before, that we were amazed by the fact that regulators did not understand the systemic nature of sovereign credit default swaps. These swaps, which in the case of Euro-zone sovereigns are denominated in US dollars would be the link here, connecting US financial institutions with Euro liquidity problems.

The Fed last Sunday already extended currency swaps to the ECB in a very murky way, which even caused a heated debate in the US Senate. What do you think would happen under a terminal situation, where the European banks’ risk as counterparties would jump exponentially?

And then, friends, would you hold US dollars as a reserve asset, knowing that they are thrown into a hole to fight the last battle?
Doesn’t this actually make gold look like a bargain at $1,240/oz?

Martin Sibileau