European Central Bank (ECB) actions taken in December to counter a potentially devastating liquidity problem in the euro zone are gaining some traction, at least for now. The key step: making $650 billion in new money available to euro zone banks over three years under the Long Term Refinancing Operation (LTRO).
This week, for example, Spain sold one-year debt at a little more than half the rates markets demanded just last month, despite a recent downgrade of its sovereign credit rating. Also, the bailed-out banks have used some of their new-found capital – though not nearly as much as was hoped for — to buy up some European sovereign debt, further easing rate pressures.
The move came just in time. European banks last month were locked in a devastating credit crunch that could have brought the continent’s economy down hard. Banks were refusing to lend to each other, mostly over fears that sovereign debt held on the banks’ books could go bad. That could have caused some bankruptcies, and bank failures could have spread quickly.
The credit situation has improved, if only for the short run, thanks to the LTRO funding. But the big picture remains risky — and in some ways confusing — because of the unusual, circular way in which funds are changing hands between banks and governments. As The Economist noted recently, banks from Spain, Greece and Italy have the deepest capital shortfalls. “Several may have to tap government bail-out funds to raise the capital, creating the circular prospect of governments bailing out their banks that are in turn supposed to bail out the government.”
Similarly, Satyajit Das notes in this piece from the website Naked Capitalism, that French President Nickolas Sarkozy has urged banks to buy euro zone government securities, to be used as “collateral to borrow unlimited funds from the ECB or national central banks.” The French President noted that “earning 6% on Italian bonds that could then be financed at 1% from central banks was a ‘no brainer’….” Das adds that “Sarko-nomics perpetuates the circular flow of funds….”
So if money is simply on a merry-go-round, why have markets responded positively, if only in the short term? Notes Wharton finance professor Franklin Allen: “… Essentially they are trying to monetize the debt.” Since the Maastricht Treaty forbids the ECB from simply printing money and buying up debt, “this is an attempt to do the same thing by allowing the banks to borrow and then buy the debt.”
In the ongoing European debt crunch saga, all sides seem willing to use more debt to continue gambling on an eventual economic recovery that can reverse the tide. But with Europe now widely believed to be heading into – or already in – recession, many economies are shrinking and so are government revenues, and thus the ability to service all of this debt.
And the LTRO approach, while relieving the private and public credit crunch in the short term, carries significant new risks, Allen points out. “First of all, the banks are taking on risk. If there is a default on the government bonds they buy, they will likely go bankrupt. This is quite possible and this why so far they have been reluctant to do this in large quantities.” The ECB also is taking a risk – “if the banks go bankrupt, they will be technically insolvent. This will cause a significant political problem.”
In this article from The Telegraph, Ambrose Evans-Pritchard and Louise Armistead cite “nagging concerns over how long the ECB itself can keep shouldering the euro zone burden, given that it has no sovereign entity behind it. The LTRO … may save the day but it also concentrates risk further for the Bundesbank and other central banks in the euro zone system, as well as private banks. The ultimate disaster could be even worse if it all goes wrong.”
So far, while the LTRO has had the effect of lowering sovereign borrowing costs for some pressed European sovereigns, it has not yet accomplished another key goal – getting banks to lend to each other in a way that increases business and consumer credit. “We see that the key refinancing markets for banks are clogged; the interbank market is basically not functioning,” European Central Bank President Mario Draghi said this week, according to Bloomberg.
Meanwhile, some debt rating agencies have downgraded credit ratings for France and Austria. Both have lost their AAA rating this week, while Spain, Portugal and Italy were dragged down two more grades recently. Portugal’s debt is now rated at a junk-bond level. Spain’s credit rating was slashed from AA- to A shortly after it announced last week that it will miss its budget deficit target by about 33%.