Why Not To Expect SMP or LTRO from ECB Next Week

The ECB meets next Thursday, July 5. Although a few members wanted to cut rates earlier this month, they did not represent a majority. Expectations are running high for some action next week. The ECB did announce last week a relaxation of collateral standards and a liberalization of criteria. We have suggested this should be understood as just as important, if not more so, than a rate cut itself. Given financial crisis, access to credit is critical and, within reason, is important than the price (or interest rate).

Maltese central banker Bonnici warned earlier today that an interest rate cut would have only limited economic impact. Some read his comments as playing down the likelihood of a rate cut next week. We demur. Instead, the comments should be understood as warning against expectations of a quick fix. In addition, by suggesting that impact of monetary policy was limited, Bonnici keeps the pressure on European officials to take stronger actions to address the crisis.

We expect the ECB to cut the refi rate 25 bp next week. At the same time, it will reduce the deposit rate to zero. Until recently, there seemed to be a reluctance to cut the deposit rate, which is the rate that the ECB pays to banks on their reserve holdings. However, as the crisis deepened, a few officials have intimated that is not longer the obstacle it once may have been.

As an side, the US Federal Reserve had previously talked about reducing the interest rate it pays on excessive reserves. Although there has not been much talk recently, as the Fed contemplates what additional action may be necessary in the economy deteriorate further or in response to the looming fiscal cliff, that may weigh on activity in Q4, cutting or eliminating the IOR (interest on reserves) may once again resurface as a possibility.

There are two main reasons why another LTRO is unlikely, though some observers continue to call for it. First, the funds made available in the two 3-year LTROs have not been fully deployed. Consider that through April, Spanish banks bought some 70 bln euros of Spanish government bonds. They borrowed some 227 bln euro in the LTROs. Spanish banks purchases incidentally were greater than the amount of debt Spain sold as they absorbed the selling from foreign investors as well. Italian banks borrowed around 255 bln euros from the LTROs and have bought about 85 bln euros of government bonds.

If the first reason then not to expect another LTRO is that the funds from the previous operation have not been fully utilized, the second reason is that to the extent they have been used, it has strengthened the dangerous link between the sovereign and banks.

Consider Spain. Roughly 2/3 of Spanish government bonds are owned by domestic banks, pension funds and insurance companies. Their holdings were closer to 50% at the end of last year. By way of comparison, a little more than a third of French government bonds are own by domestic banks and financial firms.

In Spain, as was the case in Ireland, the weak banks are weighing on the sovereign. In Italy, for the most part, it is the weakness of the sovereign that is an important weight on Italian banks.

Spain, Italy and France have argued for ECB action and in particular a resumption of its sovereign bond support program (SMP). However, this also does not seem likely at this juncture. To be sure, it is not simply that Germany objects. After all, as we saw last week on the collateral decision, Germany can be and has been over ruled at the ECB.

Rather the reason not to expect a resumption of the SMP program is that the overwhelming majority of the ECB are concerned that in the current context, ECB bond purchases would blur the distinction of monetary and fiscal policy. In addition, as more than one ECB official has noted, the EFSF/ESM was authorized a year ago to buy sovereign bonds. Countries do not want to go that route because there would be conditions attached.

Creditor nations cannot allow unconditional ESM/EFSF buying of bonds because that would amount an improper/illegal transfer. It can be changed at some juncture, but would require a modification in the current treaty, which is still not fully approved and a delay, pending the German Constitutional ruling, may see a delay in the start of the ESM past the July 9 back-up launch date.

As of now, no country has formally asked for the EFSF/ESM to purchase their bonds.