A Central Bank Doing What It Should
New York TimesBy FLOYD NORRIS | New York Times – 23 minutes ago
“Talk tough, and open the vaults.”
That should be the slogan of Mario Draghi, the president of the European Central Bank.
In recent weeks, the new president publicly insisted the central bank would never do any of the things that Germany opposed. The bank would not drastically step up its purchases of Spanish and Italian government bonds. It would not directly finance European governments. It would not backstop European rescue funds or print money that the International Monetary Fund could use to bail out governments.
It would do only what central banks normally do. It would lend to banks.
It turns out that may be enough to stem the European crisis for at least a few years, and go a long way to recapitalizing banks in the process.
That fact only became clear on Wednesday, although Mr. Draghi announced his intentions on Dec. 8, when the central bank said it would offer to lend money to banks for three-year terms, in unlimited amounts, at a very low rate.
In reality, it was an offer banks could not refuse. They will initially pay the central bank’s official rate of 1 percent. But if the bank lowers the rate in coming months — as it is widely expected to do — the rate on these loans will drop as well.
There is no limit on what the banks can do with the money. But there is an obvious, virtually risk-free, option. A bank can buy short-term securities of its own government and pocket the difference — up to four or five percentage points — for the life of the securities.
On the same day the central bank announced its lending offer, Mr. Draghi held a news conference at which he talked very tough. He said he was surprised that a speech he had made a week earlier had been widely interpreted as signaling the bank was ready to make large scale purchases of Spanish and Italian bonds. He threw cold water on the idea of the bank funneling money to countries through the I.M.F.
Many observers — including me — focused on what he told reporters, not on what he announced. Bond yields rose. The yield on three-year Italian bonds leaped to 6.6 percent on Dec. 8 from 5.9 percent. For Spain, the comparable rate rose to 5.1 percent from 4.6 percent. Stock prices plunged, with the main Spanish index down 2 percent and its Italian counterpart off more than 4 percent.
It was more than Mr. Draghi’s rhetoric that had misled the market. In normal times, borrowing from a central bank is seen as a sign of weakness, and banks hate to do it for fear word will leak out that they had to do it. And banks have come under pressure to raise more capital in part because of their exposure to dubious government paper. Would they really line up to buy more, even with favorable financing?
The answer is yes. On Wednesday, the European Central Bank announced that 523 banks would borrow a total of 489.2 billion euros ($640 billion). That was above virtually every forecast.
On Tuesday, the same day the banks were putting in their requests for loans, Spain held an auction of Treasury bills. A month earlier, it had to pay an annual rate of 5.1 percent on three-month bills and 5.2 percent on six-month securities. This time the rates were 1.7 percent and 2.4 percent. Credit that plunge to Mr. Draghi.
Rates have also fallen significantly on government debt out to three years, but the declines in longer term rates have been smaller.
It now seems obvious that this was what Mr. Draghi had in mind. Spain and Italy will be able to borrow money from the market at rates they can live with, but this move is unlikely to have much effect on long-term rates. If those stay high, the pressure for austerity, as Germany demands, will remain.
There is no assurance that the banks will use all, or even most, of the money they borrowed, to buy government securities. It would be nice if some of it were lent to the private sector to spur growth and investment. But the logic of putting it in two- or three-year government notes is obvious.
Spanish two-year securities now yield about 3.6 percent, while Italian ones offer 5.1 percent. A bank that uses central bank money to buy them will clear the difference between those rates and 1 percent. The spread will be a little larger when the central bank lowers rates in a month or two. The securities will mature well before the loans come due.
What can go wrong for a bank that follows that course? The obvious one is that the governments default. But for a Spanish bank owning Spanish bonds, or an Italian one with bonds from its government, that is really not a risk worth worrying about. They would be dead whether or not they had bought more bonds.
Without this money, there was another risk: that the banks would lose access to financing before the securities matured. That risk is gone. At the same time the European Central Bank took steps to increase the assets it would take as collateral for loans. Now it will accept mortgage-backed securities that were rated single-A at issuance, which means they are probably junk now. And it has asked banks to come up with ways of measuring risks that the central bank can sign off on, in order to take more kinds of paper as collateral.
Theoretically, there is one other risk to banks that take the three-year loans and buy government bonds. The rate on the central bank loans would go up if it raised its base rate, while the yields on the securities bought would not increase. If the central bank raised its base rate sharply, the profits would decline or even vanish. That is not going to happen.
Instead, this move will help to recapitalize European banks over time. Assume a spread of 2.5 percentage points for the three years. On the money borrowed this week, that would produce 37 billion euros in profits for the banks. And there will be another chance for the banks to take down three-year loans in late February.
Thus it turns out that the December European summit meeting did yield something tangible and important. But that did not come from the proposed treaty that would lock in government promises to sin no more by spending too much. Even if that really mattered, the politicians seem to be having trouble reaching agreement on the details, and the amount of money the governments will send to the I.M.F. has been scaled back. But the central bank did do its part, just not in the way many had expected.
The most important problem facing euro zone members in the longer run is getting their economies to be competitive with Germany, whose costs have risen less over time. In the pre-euro days, that could be accomplished by occasional devaluations of pesetas or liras against the German mark.
There are two ways that could happen. The benign one for Europe would be for German costs to spiral, as its economy boomed and suffered inflation. The not-so-nice one calls for deflation and mass unemployment in other countries, as well as for increases in productivity. That is effectively what is being tried, and it seems to have worked in Ireland.
It may be starting to work, a little, in some other countries. The Organization for Economic Cooperation and Development estimated on Wednesday that unit labor costs fell 1.3 percent in Spain in the third quarter, largely because of better productivity. But it said such costs rose 1 percent in the euro zone as a whole, while they fell 0.3 percent in Germany. In other words, the gap seems to be widening, not shrinking. There was no estimate for Italy, which tends to be slow in producing economic statistics.
In the short run, Mr. Draghi has avoided disaster. In the longer run, it is hard to see a course that enables the peripheral countries to regain prosperity and competitiveness while keeping the single currency.
Floyd Norris comments on finance and the economy at nytimes.com/economix.