MOST of the Eurozone rescue package – EU budget funding, Eurozone intra-government loans/guarantees, the IMF contribution – will have no implication for liquidity. The key issues are the scale of European Central Bank (ECB) government bond purchases – as well as the impact of its expanded lending operations and the US dollar swap on the Eurozone and US monetary base.
• The ECB said that its bond-buying plan is intended “to ensure depth and liquidity in those market segments which are dysfunctional”. It has given no indication of the possible scale of purchases, in contrast to the Fed and the Bank of England, which both published numbers when they embarked on QE.
• Buying must be large to have a significant impact on global liquidity. To boost G7 broad money by one percentage point, the Eurozone money supply (defined as M3) would need to rise by about three percentage points. This would require purchases of €280bn. (This compares with the ECB’s covered bond purchase programme, announced in May 2009, of €60bn.)
• The scale of intervention by the Fed to stabilise the US mortgage-backed securities (MBS) market also suggests that large-scale buying will be required. The Fed purchased $1.25 trillion of agency MBS, equivalent to about 25 per cent of the outstanding stock. To buy 25 per cent of outstanding government debt in the Pigs (Portugal, Ireland, Italy, Greece and Spain) markets, the ECB would need to spend €420bn.
• The ECB has indicated that its bond purchases will be sterilised but the Eurozone monetary base may nonetheless expand because of the simultaneous decision to reintroduce full-allotment three-and six-month repo operations. In contrast to the US and UK QE variants, however, there is no explicit aim to boost banks’ reserves.
• The US dollar swap arrangements with the Fed have the potential to increase the US monetary base. The Fed, however, has been draining bank reserves in recent weeks, probably in response to stronger economic news, suggesting that any expansionary impact from swap lending will be sterilised.
The rescue package will suppress contagion and ease near-term financing but does not remove longer-term solvency concerns based on doubts about the willingness of electorates in the Pigs to accept fiscal stringency.
There is a risk that investors will use a bounce in asset prices to accelerate capital withdrawal. Central bank actions could possibly be a “game-changer” in terms of the liquidity backdrop for markets but the ECB’s reluctance to quantify bond-buying and its bias towards sterilisation argue for caution. A more positive interpretation would be warranted in the event of an early significant pick-up in the Eurozone and US monetary base. We shall soon find out.
Simon Ward is chief economist of Henderson.