What the central bank giveth, only the central bank taketh away

When I first started working at a bank they told me to do liquidity forecasts for the money market desk. It was a relatively simple, yet educational exercise. I would look at a given month and put together a table of cash inflows to and outflows from the system. For example, when there would be a bond redemption or a coupon payment, it would mean an increase in liquidity. Conversely, if the finance ministry were to issue bonds, it would drain some money from the system. These were just daily moves in liquidity but they were absolutely key for the money market rates. Believe me, you don’t want to make a mistake when doing that…

But the thing is that this was just forecasting of changes in maturity of money in the system. After all, the mere fact that the finance ministry pays out a coupon doesn’t mean that there is more money in the system. The finance ministry cannot print money so they would simply move it from their account to the accounts of bond holders. On that day overnight rates would normally drop but the system would balance itself quite quickly.

Fast forward to more interesting (aka post-Lehman) times. The central banks around the world have been printing money at a spectacular pace and many agree (myself included) that quite a few of developed economies are in the liquidity trap. Naturally, the increase in central banks’ balance sheets has led to a significant build up in excess liquidity, which – as we know all too well – usually ends up back at the central bank’s deposit facility. This is beginning to raise concerns in both developed and emerging economies. Let me give you three examples from recent weeks in the European Union (in order of appearance):

  • Hungary’s central bank is planning to limit banks’ access to the two-week NBH bills (open market operations). More details can be found here. NBH Governor Matolcsy is quite angry that the central bank needs to pay banks for the liquidity they park in this facility. He is pointing in the direction of foreign banks (I explained the mechanism in the post entitled The Invisible Carry), but we can assume this will eventually be extended.
  • Last week, Mario Draghi said the central bank was open to negative rates on the deposit facility.
  • This week, Nationa Bank of Poland’s Governor Marek Belka said that banks had too easy lives because they were parking PLN140bn using weekly open market operations and earning the repo rate without any problems.

Many commentators and indeed the central bankers themselves have been mentioning that the idea behind those measures is to make the banks lend more. It is often claimed that the liquidity in the banking system should be helping the economy recover, instead of making banks money. But this is a very simplistic approach to how banks operate.

Let’s say that a banking system has excess liquidity of 1,000bn (never mind how it got to that state). This money is kept at the central bank in weekly open market operations and earns 0.05%. Let’s then assume that the central bank slashes this rate to -1%. What happens?

Some banks may conclude that using the central bank is not a very smart thing to do anymore and will go and buy, say, 3-month TBills. But who will they buy them from? Finance ministry? Ok, but then what will the finance ministry do with the money it gets from the bank? It will pay teachers’ salaries (among others, of course). What will the teachers do? They will keep it on their bank accounts, which means the money will have returned to the system and we’re back at square one, but with one happy finance minister who just sold some TBills.

Other banks will conclude that maybe they will take the money they’d normally put at the central bank, swap it into another currency, eg the USD and buy some USD-denominated assets with it. The price of USD in the swap market will increase (and the price of the local currency will decline) but ultimately the money won’t disappear and will return to the central bank. The process will, however, lower fx swap rates.

Perhaps there will be one bank whose CEO will feel patriotic and will want to lend money to “hard-working entrepreneurs up and down the country”. Why the decline of deposit rate by 105bp would persuade her to do that is beyond me, but we can make such an assumption. So if this bank lends some money for the new investment project, then the company in question will spend the money and the money will… come back to the system! At the end of the day, there will still be 1,000bn sitting with the central bank. Just at a different price.

I don’t question the fact that such a move will persuade banks to search for higher-yielding assets, ie loans but what I’m trying to explain is that the liquidity in the banking system is like a hot potato. The central bank controls how much money there is in the system (using various ways, eg printing money, changing the reserve requirement etc) and the market only needs to decide the price of this money. The only way that lowering rates to the negative territory impacts the amount of cash in the system is because the central bank will be returning 99% of the money placed in it back to banks. But then which of the major central banks could even contemplate shrinking its balance sheet at the time when the global economy remains exceptionally fragile?

What I think discussions like the ones taking place in Europe will lead to is significant re-pricing of interbank rates (BOR-OIS spreads could decline massively as banks start passing on the potato) and an increased demand for government or quasi-government bonds by banks’ assets and liabilities management desks (ALMs). Perhaps this is the point of the whole exercise. Then again, isn’t it yet another version of crowding out and actually forcing banks to play the carry in government bond markets? Hard to see how that should please politicians but perhaps this is the only path to rejuvenate the credit action. I really don’t like growth implications of such a process. Unless of course the ultimate beneficiaries, ie the governments, use the extra demand for their papers to increase public spending… But I will spare you, Dear Reader, yet another discussion about consequences of austerity. There’s this chap in the US who does that several times a day.

 

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Systemic ain’t what it used to be

I remember that in the first days after the bankruptcy of Lehman Brothers, many believed that the collateral damage would not be terrible. I distinctly recall asset managers who were still eager to discuss idiosyncratic factors in some emerging markets. Not that I was so much smarter back then – after all, I did not send an email entitled “SELL EVERYTHING”. Of course shortly afterwards came an avalanche and dominoes started falling. All of a sudden everything appeared systemic, even things you wouldn’t normally care about.

Just to give you a few examples from my turf:

  • Iceland was relevant because of huge assets of local banks outside of the country (aka Icesaave);
  • Hungary (and CEE in general) was key for survival of Austrian and Italian banks;
  • Latvia threatened the stability of the banking system in Sweden;
  • Ukraine was a big risk for French banks;
  • The Middle East… well, it’s always considered to be a tail risk anyway.

One could extend this list quite a bit.

Considering the fragility of the financial system back then, any of those factors could’ve spiralled out of control. Therefore we had various programmes, such as the Vienna Initiative which were aimed at ring fencing potential fallout. When that initial phase of panic ended (with the London Summit) we had a brief period of calmness followed by the mighty Eurocrisis.

This one has been very similar to the initial “Lehman” stage. First came Greece, which initially was considered to be not that relevant. That was the case until roundabout the PSI Summit of 2011, which – perhaps inadvertently – wreaked havoc in the system. There was also Ireland with its “bad bank” ideas and the Iberia with all sorts of problems. And then, again, everything became systemic and potentially fatal. The culmination of it all was in my opinion when a) the market went after Italy and b) people wanted the Bund to start trading with a credit premium (search Bloomberg headlines towards the end of 2011 if you want to see that actually was the case).

Like with the Lehman, many people missed the Eurocrisis trade and began making up for that by creating more or less far-fetched implications. I described this mechanism in one of my previous posts about Slovenia. But does anyone really care about Greece or Ireland anymore? I know there’s punting going through in GGBs and some when-in-trouble-double funds made a killing buying Irish bonds but in terms of global significance this is barely relevant. Similarly, we shouldn’t really care about Cyprus, although some people are trying to persuade us it’s yet another reason to buy gold bitcoins and hide.

In this vein, I was actually pretty impressed with recent comments from Jeroen Dijsselbloem. He is right and he knows he can take a bit of a gamble by speaking his mind: not everything is systemic. And if something is then, well, we have the Draghi Doctrine.

Granted, Europe is pretty screwed economically and this won’t change anytime soon but this is a completely different set of issues than forecasting the total annihilation of the financial system. The two most important measures of stress, i.e. the cross-currency basis between EUR and USD as well as the BOR-OIS spread are telling us that we should change the way of looking at European affairs. And maybe this is the answer to a tweet from Joe Weisenthal asking why on Earth is the euro so stable. The euro has plenty of reasons to fall and I have been suggesting short EUR/EM positions lately but systemic just ain’t what it used to be.