10th November 2011
The European Central Bank has been thrust into the limelight in recent days with its efforts to support the Italian bond market which as I explain below are currently failing and are likely once all the can kicking is over to leave Euro zone taxpayers with a large headache.
The Bank of England
Last month the Bank of England announced an increase of £75 billion in its Quantitative Easing programme, meaning that the total amount would be £275 billion once it was completed. Since then it has been pressing ahead with some gusto. Whilst it website is out of date giving details only up to the 27th of October of total purchases (£214.6 billion) we can gain information by looking at each days operations. Yesterday it purchased some £1.7 billion and today it plans another £2.5 billion so at current rates it is purchasing around £10 billion a week. So unless it slows down it will not be long before it has bought its allocation.
Accordingly it is by no means impossible that it will announce an increase in its target number of purchases today and this would not be such a fundamental change in policy as one member Adam Posen has been calling for a higher number and the October minutes told us this.
'In terms of the immediate decision, the Committee considered a range of asset purchases of between £50 billion and £100 billion. Committee members agreed that differences in the impact of asset purchases within this range were, in current conditions, likely to be outweighed by the degree of uncertainty about the outlook for inflation. Moreover, the size of the asset purchase programme would be kept under review in the light of subsequent analysis and events.'
What do I think?
Firstly I wish to make it clear that I consider this to be a policy error as I believe that the policy of QE has contributed to inflation levels in the UK being driven higher with the official measure of Consumer Price Inflation running at an annual rate of 5.2% as opposed to its target of 2%, so considerably more than double. If we look at the Bank of England’s original rationale for this policy from its website we can see that someone there agreed with me:
'The MPC therefore needs to provide further stimulus to support demand in the wider economy. If spending on goods and services is too low, inflation will fall below its target.'
QE is presented there as a policy to help achieve the inflation target from below it i.e it is inflationary! This is somewhat contradictory with announcing an expansion when rather than being below target (as the Bank of England predicted) inflation instead exceeds it by a considerable amount.
If we move on from my view to looking at what the Monetary Policy Committee will think then I feel that Adam Posen will propose more QE today. If we look at the UK economy he may get some support but with the latest economic growth figure being 0.5% I suspect at least some MPC members will vote to wait and see. The wild card which could push them into more asset purchases is the recent addition of Italy to the list of casualties in the Euro zone as her difficulties are on a different scale to the problems so far as she is a much larger economy than any of the ones which have previously hit trouble.
Also as someone who has written articles about the spread of negative interest-rates in places such as Switzerland and Japan it remains true that the UK base rate at 0.5% has room to be cut too, but this would be more of an outlier as a move.
The European Central Bank
Here we find the ECB involved in a mostly losing battle to support struggling peripheral Euro zone government bond markets. It has fought and lost in Greece, Ireland and Portugal and is currently losing in Spain and particularly Italy. This morning it has had a small amount of relief as signs of a political settlement in Italy as led to a rally in her bond market after yet another fall. We can see however the state of the ECB’s position from considering what has happened since it started buying Italian government bonds.
At the time the benchmark ten year Italian government bond yield was heading towards 6.25% and ECB intervention drove it back to 5% and for a short period in mid-August to below it. However inspite of the improvement this morning the same yield is at 7.1% so the ECB has taken very heavy losses on its buying. If we add in that it has been buying on a large scale (9.52 billion Euros last week alone) we can see that the total losses on a marked to market basis must be large.
I have been raising this issue for some time and here are my thoughts from the 6th of December 2010.
I added to this on the 6th May with these thoughts:
'The Securities Markets Programme has 76.5 billion Euros of peripheral debt on its books which must have very large losses on it. In my opinion they are larger and probably much larger than the ECB’s capital! But you see this is only the start of it as in return for its liquidity operations the ECB has accepted plenty of Greek, Irish and Portuguese bonds. Hows that going? Dreadfully. Now the ECB has imposed haircuts on such things but these have remained mostly well behind a rather inconvenient reality.'
If we just consider these purchases by the ECB we can see that there must be serious losses on them. If we just look at Greek government bonds it was buying some of them in the 90s and some of them in the high 90s when the price is now in the 30s! Portuguese and Irish bonds have not fallen by anything like the same amount but they have had what would normally be considered heavy falls too.
Now if we bring back in the latest phase of mostly Italian purchases we can see that over 100 billion Euros has been bought. As I have discussed above there are considerable losses there too and this is of course with the ECB still buying which has the effect of supporting past purchases. A further theme of mine is exit strategies which at its most basic level can be expressed by saying it is best to have one. At the moment the ECB must feel that there is no escape at all!
Todays news has a real cost for Italy and the ECB
An illustration of how things are going has come as I type this from an Italian one year bill auction the details of which are below.
ITALY 1-YEAR BILL AVERAGE YIELD 6.087% VS 3.570% ON OCT. 11
Whilst the ECB does not take part in a primary issue it would have been buying similar debt on which the yield has nearly doubled in a month. Thats the sort of thing which is you are a bank trader gets you called into your managers office. Also as I have explained in my article on bond yields in the explainer section this is a real cost to Italy from this crisis, by my maths some 126 million Euros.
Added to this risk is all the Greek, Irish, Portuguese, Italian and Spanish bonds that have been taken as collateral by the ECB against its liquidity providing operations. I added these operations up last night and they come to 590 billion Euros. Now not all the collateral will have come from these countries but as they have had the highest yields it would often have seemed logical and rationale to use them. In some ways this is not the ECB’s problem and it does place haircuts (now) on this but what if the bank collapses and cannot repay the liquidity and the ECB is left with bonds worth much less than the liquidity?
There is also the covered bond programme where some 60 billion Euros of the European equivalent of mortgage backed securities were bought. Values are hard to come buy in such a market but the fact that the ECB plans to buy another 40 billion Euros tells us that there has been little or no improvement and less me with the thought that it may be trying to support its past purchases.
As I have demonstrated above the European Central Bank would be regarded as insolvent if it was a private-sector bank. However due to its position as a central bank it does not have to close its doors. But unfortunately for Euro zone taxpayers there are bills which will have to be paid. Some of them have already dropped through the letter box of their own national central banks as losses or profits are split by the ECB in the ratio of 8% it keeps and 92% are handed back in relative shares to the national central banks.
Nice isn't it, to hand some of the losses to the Bank of Greece or the Central Bank of Ireland isnt it? Particularly from a programme that is badged as helping them!
These losses are hiding for now by the accounting system employed which believe it or not counts interest-rate gains but ignores capital losses. But either directly via a bail out or indirectly ( lower gains from the issue of bank notes) Euro zone taxpayers look like they will be getting a large bill from this.
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