The European Central Bank’s decision to buy tarnished debt in the euro zone risks turning it into Europe’s de facto “bad bank” and putting cash-strapped governments and taxpayers on the hook for yet more money.
The ECB was forced to abandon its long-held opposition to buying government debt last week in an effort to calm the debt crisis gripping Greece and other weak euro zone countries. [See IJ web site - http://www.insurancejournal.com/news/international/2010/05/12/109779.htm#axzz0oH9B1FYW ].
The decision has had a mixed reception. Many analysts have welcomed it as a sensible move, pointing to the instant success it has had in bringing down out-of-control market borrowing rates for the region’s most indebted states.
Others, however, including heavyweight ECB policy maker Axel Weber, who heads Germany’s Bundesbank, have criticized it as a step too far that could create inflation dangers by expanding the money supply.
Economists also warn it leaves the ECB highly exposed to any Greek default, while providing commercial banks with a pain-free way to offload Greek debt that they have on their books, along with other unwanted euro zone bonds.
The ECB’s program potentially also involves direct financing of companies through buying corporate debt, and while the bank can in theory sell bonds as well as buy them, analysts expect activity to be one-way for some time. With markets still nervous, any halt to net purchases of government bonds could quickly permit yields to bounce back to crisis levels.
That makes the ECB look rather like the “bad banks” some governments have set up to cleanse their banking sectors, and ramps up the central bank’s risk profile.
“It’s swapping bad assets against good so, while it’s not going to increase the size (of the ECB’s balance sheet), it will deteriorate the quality,” said Charlez Wyplosz, professor at the Graduate Institute of International Studies in Geneva. “It’s a transformation of their role, pretty much like other central banks have done. The others did quantitative easing; they (the ECB) are doing qualitative easing.”
The ECB’s scheme is much more conservative than programs by other big central banks during the global financial crisis. The U.S. Federal Reserve has more than doubled the size of its balance sheet to about $2.3 trillion by buying mortgage-backed securities and debt as well as longer-term U.S. Treasuries.
By contrast, the ECB has already announced plans to sterilize its bond-buying, absorbing back the funds released by taking one-week deposits from banks.
Announcing the plans on Monday, it revealed it had settled €16.5 billion [$20.476 billion] worth of bond purchases by last Friday. That is minor compared to the €2 trillion [$2.482 trillion] size of euro zone central banks’ combined balance sheet, but the ECB has not put any limit on how many government bonds it will buy.
“It depends on how much they buy, of course, but if the purchases get to a scale of around €300 billion [$372.3 billion] or more, it really does raise questions about the risk being taken by the ECB,” said Marie Diron, a former ECB economist who is now at Oxford Economics in London. “They don’t have the full information on the state of public finances in these countries.”
DEFAULT, INFLATION WORRIES
A combination of large-scale buying and a Greek debt default or restructuring would leave a gaping hole in the ECB’s finances, and could inflame the ECB’s relationship with governments if it is forced to turn to them for help.
Greece currently has €300 billion [$372.3 billion] of sovereign debt, most of which is held by Greek and other European commercial banks. A Reuters poll of economists last week, taken after the European Union announced a trillion-dollar financial safety net for the region, found them estimating a 10 percent chance of a Greek debt restructuring in the next 12 months.
If Greece defaulted or restructured, the hole left in the collective balance sheet of euro zone central banks would be far larger than the €5.7 billion [$7.074 billion] set aside for losses after Lehman Brothers and an Icelandic bank went bust in 2008 without repaying money borrowed from the ECB via subsidiaries.
In the same way, the ECB would face losses if it bought bonds issued by a company which later collapsed, although so far market participants have not reported buying of corporate bonds.
If Greece defaulted, it might spark a chain reaction of bank collapses, leaving the ECB with more bad assets on its books.
Deutsche Bank economist Gilles Moec said the ECB and national central banks had buffers to protect against any losses, but these might not be enough in the case of a “systemic” loss. “The first line of defense is to call on its capital or reserves,” he said.
The ECB and national central banks had combined capital and reserves of €77 billion [$95.6 billion] at the end of April. Measured against total assets of €1.894 trillion [$2.35 trillion], this gives a leverage ratio of 24.6 times capital. As a comparison, many big commercial banks have ratios around 30 times or higher.
If the ECB follows the same approach as it did in 2008, any losses from defaults would be shared among the national central banks according to their share of ECB capital — meaning Germany and France would be hit with the biggest share.
German Chancellor Angela Merkel’s coalition government has already felt the anger of voters on the issue of using taxpayers’ money to rescue Greece, suffering a major regional election defeat earlier this month.
“As the member states have to provide additional capital to their own central banks, in the end the stronger euro area countries — mainly Germany and France — would have to take up potential losses related to the ECB’s asset purchase program,” Citi economist Juergen Michels wrote.
Geneva’s Wyplosz said that if governments did not have the resources, there would be a risk of a vicious circle which could end in the ECB printing money. “We are going in circles here. We have governments which are in very difficult situations, that are being implicitly being bailed out by the central bank,” he said. “Everybody is bailing out everybody without any cash. The end of the story is that somebody needs to print the cash and that is the central bank and that’s where we get inflation threats.”
(Additional reporting by Mark Felsenthal; Editing by Andrew Torchia)