Notes on the ECB

On April 1st I had a consultation with a group of managers from financial and corporate firms. These are the notes I had prepared for that purpose. 

  • COVID-19 creates huge aggregate supply problems, but also very serious problems for aggregate demand which monetary policy can address (but much better if accompanied by fiscal action)
    • Lock down impedes consumption
    • Income falls because of lock down
    • Uncertainty effects on consumption and investment
    • Tightening of financial conditions (equity and spreads) on investment and possibly also on consumption
    • Trade falls effect mostly export and investment
  • The ECB made clear that it understood the gravity of the issue and is putting all its force to fight the upcoming recession
  • The EU institutions are like a plum tree, if you shake them enough the plums will fall. But the ECB’s plums come earlier and bigger than the plums of other institutions (not surprising for a federal institution with precise decision making and effective tools)
  • Before COVID-19 I thought the ECB was constrained in further using conventional and unconventional tools to regain price stability defined as 2.0% and I was suggesting new tools (see below in particular Derivative Market Program and adding bank loans to purchases)
  • But the perspective is completely different now, the objective is not just getting closer to 2.0% inflation, but fighting the recession, basically confining damages to the flow (GDP) while safeguarding (mostly intangible) capital, which would allow a quick recovery towards pre-crisis level
  • The first ECB package was clearly insufficient, so much that a much stronger one was needed less than a week later. Still it contained some strong capital relief measures decided from the supervisory, semi-detached part of the ECB. I have estimated that this could mean between 4 and 5% capital relief, which could translate into an impulse to bank credit between 2 and 10%, very different estimates one from the other but both deserving the adjective of large with respect to the 1.5% average growth of bank credit since 2010. This was further reinforced by the more recent decision of the supervisory authority that banks should not distribute dividends or carry out shares buybacks and the call to be prudent with bonuses. The capital relief freed 120 billion, the dividend decision adds another 30.
  • The capital relief measures were possible because of the balance sheet strength accumulated after the crisis
  • There is also a general message in the recent actions by the supervisory wing of the ECB. Macroprudential measures find a strong actor in ECB supervision. This is an important message given that it was not clear before the recent moves who was responsible for this kind of policy in the EU
  • With the second ECB program allowing more than one trillion of purchases (750+120+180), the ECB gave itself huge room to act
  • This was reinforced by the flexibility recently announced on both the capital key and the purchase limits applying to the PEPP
  • Significant accompanying measures were also the extension of the collateral framework with wider use of bank loans to guarantee refinancing operations as well as the decision to also buy non-financial commercial paper. In terms of financing firms, also the pre-existing ability to purchase corporate bonds on the primary market is important
  • An important political signal was given by the recent interview of Ms. Schnabel not only defending the decided program but clearly giving her support to additional measures, if they will turn to be needed
  • The scarcity problem in purchases (not enough bunds to buy) is no longer there, because of both the relaxation of the constraints and the large new issuance that will come from Germany (mostly in bubills?)
  • The ECB could also substantially increase its purchases, on the secondary market, of ESM bonds, thus supporting the issuance of bonds from the ESM to grant credit to governments, hopefully for a coordinated fiscal sanitary and countercyclical action
  • The reactivation of the swaps with the Fed is also a critical step. I must confess that I feared central banks, and in particular the Fed, would not be able to do this given the nationalistic attitude of the US President. I was impressed by the independence shown by the FED on this issue
  • This is confirmed by the decision to add a repo facility for central banks, which extends the number of central banks who can, one way or the other, draw liquidity from the Fed.
  • To compare the responses of US Federal Reserve and the ECB policy three basic differences between the two central banks have to be taken into account:
    • The $ is much more of a global currency than the €
    • The US financial market is much more articulated than that of the EU, dominated by banks
    • The ECB has a universal approach to counterparties (all those with a banking license, meaning hundreds and potentially thousands of institutions) the FED has more of a tiered approach
  • Of course, the question is now whether there is more ammunition for the ECB to fire. My sense is that there is more. Classifying the possible future measures along two dimensions, efficacy and difficulty to decide, my list is as in the following table.

New measure

Efficacy

Difficulty of decision

Net efficacy v.s, difficulty

Extending purchases to bank loans

xx

x

x

Yield curve control

x

x

0

Derivative market program

xxx

xx

x

Increasing purchases

x

x

0

Going direct (helicopter)

xxx

xxx

0

Decreasing deposit rate

x

x

0

Decreasing TLTRO rate

xx

x

x

Swaps/Repos from ECB to non-€ central banks

 

xx

x

x

 

  • In terms of a €-area fiscal answer I see an optimal response, which is unlikely, and a decent response, which has more probability of success.
    • The optimal response would see the implementation of a temporary fiscal union, with the EU council deciding that an extraordinary fiscal program is needed, the Commission and the Eurogroup implementing it and the ESM acting as €-area debt office. Finally, operations would be carried out by national governments
    • The decent response would see – a EU financed unemployment benefit system, a hybrid between corona bonds and ESM issuance/credit line and, over a longer horizon, recovery funds in the Multiannual Financial Framework (MFF)
  • ‘Corona bonds’ is an ambiguous term. Basically, I think they imply EU issuance but use based on need, not on same key as issuance. E.g. Italy would probably get more than it is responsible for.
    • What are key risks for countries with stronger balance sheets like Germany and the Netherlands? Of course, they would lend some of their credit worthiness to countries that have less of it.
    • How should the Eurozone reconcile clashing perspectives / needs of its member countries? There are two dimensions here: the solidarity dimension and the self-interest dimension. Both are important, but the latter is more important than the former. Solidarity is affected by the obvious remark that some countries (e.g. Italy) find it difficult to answer to the shock because of their precarious debt situation, which is clearly their responsibility. A solidarity dimension remains, but not as strong as it could be. The self-interested dimension has no such weakness: dramatic consequences for a €-area country would have dramatic consequences for the entire €-area. Just think of what Greece did and multiply by a factor of 10.

 

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