Draghi lays out toolkit to save eurozone
Investors picking over Mario Draghi’s comments after last week’s European Central Bank meeting have been left wondering not what is on the table to save the eurozone, but what is not.
Financial markets have been cheered by the prospect that the ECB “may consider” buying short-term government debt, albeit on the condition that ailing governments such as Spain and Italy first ask for help from the eurozone’s rescue funds. The impact is already being seen in lower sovereign borrowing costs that are filtering down to banks and companies.
But in his quest to do “whatever it takes” to save the euro, and given that “financial market fragmentation” remains a key concern for the ECB, Mr Draghi may find it easier to use more unusual – even emergency – measures aimed at banks and companies first.
When funding markets dried up last year, the ECB took the unprecedented step of offering banks access to cheap three-year loans under its longer-term refinancing operations (LTRO). Banks tapped about €1tn from the LTRO in December and February and some investors believe a third, three-year LTRO is on the cards, possibly even before the end of the year.
Alberto Gallo, head of European macro credit research at Royal Bank of Scotland, says the ECB could even increase the maturity of existing LTRO to five years. “That would provide banks with a closer match to the maturities on their loans to customers.”
Huw Pill, chief European economist of Goldman Sachs, says: “If you want to help small and medium-sized companies in Spain and Italy, you need to go through the banks. When Spanish banks were having trouble getting access to unsecured term funding in September and October last year, the ECB stepped in with the LTRO.”
The LTRO addressed liquidity problems, brought down funding costs for banks and galvanised public debt markets into action. But as accessing the ECB funding required collateral, it also tied up banks’ assets.
Some are unconvinced by the need for another LTRO given that it has so far not resulted in banks lending more to the real economy and that liquidity is no longer the main issue for banks.
Another LTRO would only help at the margin, says Alastair Ryan, banking analyst at UBS: “Italian banks don’t need it. And it would provide no benefit for Spanish banks other than allowing them to swap three-month debt for three-year debt.”
But as long as capital remains scarce and banks have to meet strict capital adequacy ratios, banks are unlikely to resume lending. Recapitalising the banks directly is one solution but, as seen in Spain, expensive.
Mr Gallo suggests another option would be for the European Stability Mechanism, the successor bailout fund to the European Financial Stability Facility, to purchase directly bank securities, in addition to sovereign debt, with support from the ECB.
It could be a “gamechanger”, says Mr Gallo, helping increase bank capital ratios, with taxpayers only taking on debt rather than equity risk, as in the Spanish bank recapitalisations.
The ECB could also use more effectively its programme to buy banks’ covered bonds, debt backed by a pool of collateral, usually mortgages. Analysts, though, say that seems unlikely given that some banks have been buying back debt and repackaging it to pledge as collateral with the ECB.
More likely is that the ECB makes it easier for lenders to access the central bank’s facilities by loosening credit criteria for the third time in five months. The ECB could reduce the “haircut” applied to securities pledged as collateral in monetary policy operations to protect the bank in the event of a default.
“To be really flexible, those haircuts potentially could be zero, meaning that they could, for example, offer three-year unsecured funding,” says Mr Pill. “The ECB could also accept a broader range of collateral. Such measures could be targeted at supporting new lending, rather than just refinancing existing loans,” he adds.
The ECB could go further, bypassing banks and buying the short-term, publicly traded debt of large Spanish and Italian companies, a number of which now carry a higher rating than their sovereign but are struggling to raise debt in public debt markets.
Mr Pill says measures directed at banks or corporates only offer a short-term “palliative” to eurozone woes. To be really effective, they need to be used in parallel with measures directed at the sovereign.
Philippe Bodereau, head of European credit research at Pimco, agrees. “If you look at the various options – LTRO 3, buying covered bonds, buying unsecured debt or corporate bonds – these are not top of the list. It is more important that the ECB deals with the sovereign issue,” he says.
But while the market is focused on the ECB buying short-term debt, it is conditional on Spain or Italy first applying for a full bailout, which they are reluctant to do.
“Draghi has opened the box to say he could do any and all of these [measures] to ensure the survival of the eurozone,” says Ian Kelson, head of global fixed income at T Rowe Price International. But in the short term, he says, it might be easier for the ECB to launch another LTRO or ease collateral rules.