Saturday 14 January 2012

The Mother of all Carry Trades

The ECB’s decision to lend EUR 498 billion at an average rate of 1% for 3 years to European banks is turning into the mother of all carry trades.

The unspoken premise behind these loans was that banks would use part of these loans to re-invest in sovereign debt. As Bloomberg stated

Italian two-year notes rose for a third day and Spanish securities rallied on speculation the European Central Bank’s provision of three-year loans is boosting demand for the two nations’ debt.

Given that recent Italian and Spanish bond auction rates exceeded 6%, this amounts to a margin of just under 5% for banks which took out ECB loans and re-lent to these two governments. 

The Standard & Poor’s downgrade of 9 Eurozone countries yesterday evening, among them France and Italy, raises sovereign interest costs still further. This comes on the heels of a successful Italian bond auction last week

Italy issued 12 billion euros of Treasury bills, meeting its target as its borrowing costs plunged. The Rome-based Treasury auctioned 8.5 billion euros one-year bills at a rate of 2.735 percent, down from 5.952 percent at the last auction.

With Italy now downgraded to BBB+, we can expect another spike in interest costs next week.

All this has been financed by the European Central Bank and the Eurozone central banks. According to Reuters

Due to the generous liquidity provision and a bond-buying programme, the balance sheet of the ECB and euro zone national central banks has ballooned by more than 600 billion euros to 2.688 trillion in the last four months.

It is extremely doubtful whether the European Union’s citizens are aware of what this means. The ECB, in an effort to solve the banking and sovereign liquidity and solvency crises, has expanded quantitative easing (QE) of a very different sort. In “standard” QE, the [national] central bank “expands its balance sheet” and buys the bonds of its national government directly.

The ECB, however, is prevented by its charter from doing so. As such, it can only intervene on the secondary market, in this case by loaning money to banks, hoping that the banks will in turn loan money to governments.

But what does this mean in terms of costs? A standard, national central bank would lend to Italy at a rate of 2-3%, driving sovereign lending costs downward. Under current legislation, the ECB is forced to  “recycle” the loan at 1% through a bank, which lends onward to Italy at a substantially higher rate. Add a rating agency downgrade and a liquidity crisis into the mix, and the bank soon gains a 4-5% margin.  

This exposes (once again) the flaw in the design of the European currency, as well as the risks in pooling sovereignty in a global world.

This also means that the democratic deficit and moral hazard are increasing to unprecedented levels. There has been no public referendum on whether or not the European Central Bank should deliberately enrich the banking sector through what amounts to a massive expansion of cheap credit, which is ultimately borne by the European taxpayer. 

Ironically, while public sector rates will increase, we can also expect a declining Euro currency value, which may result in higher inflation in some countries and segments. (The decline in consumer income due to public sector austerity will probably offset this inflationary trend).

It remains to be seen when the Tea Party will emerge in Europe, but I cannot imagine that the mainstream political parties in most countries can continue to remain unscathed in light of what we are seeing. While few European voters appear to realize what’s happening, it is only a question of time before they do.

© Philip Ammerman, 2012


  1. "This exposes (once again) the flaw in the design of the European currency, as well as the risks in pooling sovereignty in a global world."

    The Member States have partially transferred their sovereign rights, as competences, to the EU by treaty. "Pooling sovereignty" means more than these competences. Thus, in the context of a "global world", political goals are dictated by economic interests. Ergo, there is no legitimacy. Is that it?

  2. Parsing Bill Clinton, I suppose it depends on how you define "legitimacy." In this case, the ultimate guarantors of the ECB are the 17 Eurozone central banks, who in turn are ultimately guarantee by their citizens.

    What we have is a system whereby the ECB "expands its balance sheet" to an incredible amount - nearly EUR 3 trillion - and lends EUR 500 billion to banks, which are supposed to do the job (in part) of a sovereign central bank, forfeiting a huge margin along the way.

    If the goal is to "save" the banking system by providing it with liquidity, this ECB decision makes a certain amount of sense, although it has carries an important risk. If the goal is to steer funding so that third-party banks can buy Eurozone government bonds, the policy is flawed in financial terms, but legally valid, given the legal constraints defined by the Maastricht Treaty and ERM.

    My point about risks in pooling sovereignty is this: if Greece or Italy had its own currency and central bank, there are several policy options for intervening in the sovereign debt market. Furthermore, the true credit picture of these countries would be a lot clearer than it currently is under the Eurozone (and therefore, there would have presumably been far less sovereign lending).

    In a global financial market, we see the impact of unhindered investment in government bonds, both during the boom as well as during the bust. This means that classical policy responses (which are really the only things still on the books) do not work.

    And ultimately, we need to take into account the democratic deficit. If legitimacy comes from democracy, then it seems only fair that more EU decisions need to be taken not by Parliamentary vote, but by popular referendum. This is the only way the large majority of citizens will have even an inkling of what is being done in their name.

    Right now, I would say that much of what is occurring (ECB decisions, EU-wide austerity plans) is legally legitimate, in that for the most part it is being implemented by democratically-elected heads of state, but hardly legitimate in the popular, democratic sense.