The European Central Bank’s first three-year long-term refinancing operation on December 21 achieved its main task of easing funding pressures on European banks facing large-scale redemptions in the first half of this year. It has not, however, eased the pressures on governments and if they continue to struggle to roll over financing at affordable cost, the European sovereign and financial system crisis could return with a vengeance at any time.
While 523 banks across the 17 countries of the eurozone bid for €489 billion of funding, demand was clearly strongest among banks from countries in the periphery where heightened concerns over their exposure to troubled sovereign debts had shut them out of the private funding markets.
At this first three-year LTRO, banks’ priority was no doubt to prefund redemptions coming due this year that they might otherwise have struggled to meet, so potentially sparking a systemic crisis.
The big unanswered question is over the extent to which the ECB nursed a second priority of supporting government debt markets by encouraging a carry trade in high-yielding sovereign bonds. For it to meet similar success with this, investors will first need greater clarity and confidence about the willingness of the stronger eurozone countries to bail out the weaker.
The timing of the three-year LTRO announcement was highly politicized, coming on December 8, just one day before the key European leaders’ summit that agreed member states would enshrine rules in their legal frameworks at the constitutional level capping annual structural budget deficits at 0.5% of GDP.
At that moment, with outright collapse of European government bond markets and the European financial system looking distinct possibilities, the ECB faced loud and growing calls to step up substantially its buying of government bonds. By instead announcing the three-year LTRO and relaxing rules on collateral against which it will lend, the ECB signalled strongly to European politicians that it was doing everything it could within the law: propping up the banks that in turn prop up the governments.
Analysts at Barclays suggest that stronger banks from countries with less intense sovereign concerns might have held back at the first three-year LTRO in December and be reviewing their options now ahead of the second three-year LTRO at the end of February.
There are other possible sources of support for European governments: including €150 billion of IMF funding, if governments agree to supply this; perhaps €250 billion to €300 billion of remaining capacity at the European Financial Stability Facility, if it is able to parlay Germany’s share of support for its credit into affordable market access; and then direct sterilized ECB government bond buying in the secondary markets under the Securities Markets Programme, which has proceeded at more than €5 billion a week so far.
Rather than a bazooka, these sources are characterized by Citigroup analysts as a battery of peashooters. They might together appear powerful enough, though, to tide Spain and Italy over a period of market closure. Citigroup’s estimates for those country’s likely budget deficits and growth rates this year put Italy’s debt issuance need at €381 billion and Spain’s at €217 billion for 2012.
No doubt a certain amount of pressure will be brought to bear on domestic banks and other investors in the early government bond auctions of 2012 to ensure their success.
If government bond markets look to be well supported between now and the end of February, then the larger, stronger banks might be tempted into the carry trade to boost their earnings. Spread tightening in government bonds at the shorter end of the curve suggests that some carry-trade investing might have been encouraged already. Banks with access to unlimited funding through the ECB at 1% will obviously be strongly tempted to buy government paper yielding 4% or more when they face so many pressures on their earnings.
What will hold them back, of course, and limit the maturity of their carry-trade purchases, is lingering fear of sovereign defaults. If there is one thing that exercises investors in bank equity and debt more than disquiet at the banks’ poor earnings and returns, it is fear of the possibly terminal consequences of their already excessive exposures to national sovereigns. As 2011 drew on, banks paraded to investors their reductions in peripheral sovereign exposure. Investors are unlikely to take kindly to it being built up again, unless they have also become much more confident that sovereign debts are sustainable.
European policymakers must be much clearer now about the new bargain they are concocting, because so far the sequencing of steps towards a new Europe has not matched the concerns of the suppliers of credit to European governments.
The intention of the fiscal compact agreed on December 9 and endorsed by ECB president Mario Draghi in front of the European parliament 10 days later was to plug the hole in the bottom of the bucket: to stop governments borrowing unsustainably and prevent further excessive debts arising in future. That’s all very well, but if austerity today makes countries shrink their economies even faster than their deficits then those existing debts will still look unsustainable. Only if the fiscal compact leads quickly now to some declaration of at least the potential for large-scale fiscal transfers from the centre of Europe to the periphery can confidence in the sustainability of government debts return.
Banks will only pile into the carry trade if government finances are already well on the way to repair and the bet looks like a sure-fire winner.
If policymakers fail to articulate quickly a convincing vision for a European fiscal transfer union, then even the strong banks will probably use the second allotment in February just to prefund looming redemptions and then hunker down. That won’t be good for economies, markets or governments.