The recent move by central banks in the United States, the United Kingdom, Switzerland, Australia, Japan and the Eurozone (the European Central Bank) to extend US dollar credit facilities to the banking sector may presage the beginning of a "grand deal" on sovereign debt and bank refinancing.
The signs of this are visible in several decision and results of this past week.
On Wednesday, November 30th, the central banks made a coordinated move to reduce the interest rate on US dollar swap lines by 50 basis points through February 1, 2013. At the same time, China reduced its bank cash reserve ratios by 50 basis points. While this brought about a short-lived market rally as liquidity fears were alleviated, it does little to manage the fundamental problem. Signs of this became visible later in the week.
Negotiations reported today in Bloomberg indicate a plan for $ 270 billion in central bank loans, including the European Central Bank, to the International Monetary Fund, for the purchase or refinancing of European sovereign debt, including Italian and Spanish debt. This would enable the ECB to bypass restrictions on direct purchases of Eurozone sovereign bonds, and would bring the IMF in as a co-lender, as well as to enforce austerity programmes.
Der Spiegel reports that so far, the ECB has purchased EUR 173.5 billion in sovereign bonds. This probably caps the amount the ECB can spend on further sovereign purchases, absent a larger political decision. However, the Financial Times reports that bank deposits with the ECB have risen to above EUR 300 billion, indicating once again that a fundamental driver of the current credit crunch is a lack of trust, not necessarily a lack of funding.
Bloomberg reports the scale of refinancing needs in 2012, quoting a Citigroup report that Eurozone governments need to refinance EUR 1.1 trillion in 2012, while European bank s have a further $ 1,035 billion due in the same year. Der Spiegel reports that French, Italian and Spanish bond maturity to April 2012 amounts to EUR 425 billion.
The scale of the problem is therefore clear: governments must refinance a large amount of bonds maturing in 2012 (these numbers do not include the United States, the United Kingdom, or other indebted countries such as Turkey). Banks are reluctant to refinance, or unable to given the Greek PSI and increased capital requirements.
A grand deal would seek to solve these two factors in parallel, using the following steps:
1. Extending ECB lending as well as maturity terms to banks. This would require quantitative easing for the private sector by the ECB, and also extending maturities from 1 year to possibly 5 years.
2. As part of such an agreement, banks agree to repurchase a certain share of Eurozone sovereign debt, most likely in the range of 60-65% of total outstanding debt.
3. The IMF steps in with a formal austerity programme for Italy and Spain, enabling them to refinance part of their needs using ECB-IMF resources. It is likely that IMF-ECB resources of at least EUR 200-250 billion will be needed.
4. The ECB is given limited authority to continue secondary market sovereign bond repurchases, perhaps by another EUR 100-150 billion.
5. The banks agree to participate in the European Financial Stability Facility (EFSF) capital increase, perhaps to EUR 800 billion. This add about EUR 400 billion to the fund, which is then used to repurchase sovereign bonds as well as possibly bank refinancing.
6. The Eurozone adopts much stricter rules on the public finances of its member states. It is not impossible that a "new Eurozone" emerges.
7. The European Banking Association (EBA) delays its core capital increase, or alternatively allows an exemption for central bank guarantees or ECB credit lines. It is difficult to see exactly how this would work, but some solution will no doubt be found.
A key problem with this scenario is the capital shareholding of the ECB. At present, its capital is only EUR 10.76 billion, not counting of course the capital of its constituent national central banks. Nevertheless, a substantial increase in the ECB's capital will be needed to sustain a further EUR 300-400 billion increase in lending capacity.
While this is a technical operation, legal resistance to ECB lending policy among some countries, and the impaired status of certain Eurozone NCBs, will almost certainly complicate matters. But a formal capital increase will no doubt be necessary (unless of course this can of worms is kept in the dark, with the mutual agreement of all parties).
But at the end of the day, this exercise is all about two things: trust and credibility. If the Eurozone comes up with a credible grand bargain, the banking sector has no choice but to participate, since the alternative is too frightening to imagine.
Such a decision will have to be taken as soon as possible, certainly within December, if panic is to be avoided.
(c) Philip Ammerman, 2011
Navigator Consulting Group