OK, this one is a bit obstruse.
But first, a sidebar on obstuse: It’s one of my favorite words that I rarely get to use. It is an obscure and hard to understand form of abstruse; which means something that is obscure and hard to comprehend. Just love the self definitional thing… ;-)
So the European Central Bank (ECB) has announced an intent to maybe kinda sorta “sterilize” purchases while it buys Government Bonds from countries like Spain, Italy, Portugal, Ireland, etc. Why? Well, that’s a good question…
Central banks are notorious for saying one thing and doing another. For hiding their intent. This is reasonable, since $Billions can be made if you really know what way they intend to zig or zag; and in some cases that behaviour would do things counter to their intent. So it is imperative to listen closely to Central Bankers; but not trust them implicitly… The old “trust, but verify” seasoned with a bit of “And where are you hiding the truth today?”.
The first hurdle we have to get over is that “sterilize” word. Typically this is used to describe how a Central Bank buys Treasury Bonds, but takes some other action so that the act does not become a ‘creation of money’ and drive down the currency in the foreign exchange market. The Fed, for example, is the only Bank in the USA that can have an infinitely large balance sheet and can (thanks to the fractional reserve banking system) have any fraction of total assets backing what it buys. Essentially, they can create money out of nothing. (This leads to a smaller hurdle of understanding: “how do banks create money?”, so for those who don’t know, an added side bar is below.) For “sterilization” to work the bank has to not create money, but instead has to use existing money ( in a nutshell…).
This first definition below gives an idea, with their first usage being in the context of Foreign Exchange. Buying an asset in one currency and offsetting with another.
Definition of ‘Sterilization’
A form of monetary action in which a central bank or federal reserve attempts to insulate itself from the foreign exchange market to counteract the effects of a changing monetary base. The sterilization process is used to manipulate the value of one domestic currency relative to another, and is initiated in the forex market.
Investopedia explains ‘Sterilization’
For example, to weaken the U.S. dollar against another currency, the Fed would sell more U.S. dollars and buy the foreign currency. The increased supply of the U.S. dollar would lower the value of the currency. The Fed would do the opposite if it wanted to strengthen the U.S. dollar.
So The Fed might want to lever up the U.S. Dollar supply, but not have the value of the dollar drop against the Yen. They would buy some U.S. Treasuries (for example) and that causes more $US to be in the hands of government (thus being spent). At the same time, they could use some of their Yen reserves to sell Yen and buy dollars in the Foreign Exchange markets. Done properly, you get more total $US in circulation, and the value of the Yen is unchanged in $US terms.
In reality is it is more complex than this, since the Japanese Central Bank might also be trying to move the Yen… so Central Banks often try to coordinate their actions. What for you and me would be called “collusion” or “conspiracy to manipulate” markets is for them Standard Operating Procedure. They get “special” rules…
The wiki has a pretty good, if somewhat longer than needed, explanation:
Sidebar on Fractional Reserve Banking:
A bank takes in a deposit, call it $100. It then loans out that $100 to a customer, who deposits it into their checking account. So that bank has a new $100 deposit… that it can loan out to a customer who puts it in savings (creating another $100 of assets for the bank) so the bank can loan out another $100… repeat to infinity. That is the essential “magic” and “trouble” with banking that has no control on “reserves” or it’s evil twin “leverage”. To break this cycle, we require that the bank “set aside” some portion of every deposit as “reserves”. If that percent is 100%, you get no ‘expansion’ of the money supply. $100 gets deposited and ALL of it sits in the vault. Very secure, but not a lot of money being made… If the reserves requirement is 50%, the $100 gets deposited, $50 gets loaned out (and re-deposited) then $25, then $12.50, then $6.25, then $3.12, then $1.56, then… You get a doubling of the money on deposit. A typical “reserve” requirement is about 5% to 20%. This value is set by The Fed in the USA and by other Central Banks around the world. In any one country / Currency Zone there is ONE bank that is not subject to the reserve requirement: The Central Bank. They can multiply money to any degree (called ‘expanding the balance sheet’); but are encouraged to only do this during a Financial Crisis…
And the ECB Said?
So the news is that the European Central Bank is going to start buying Government Bonds issued by the various distressed countries (the PIIGS – Portugal, Italy, Ireland, Greece, Spain) to “assure the convertibility of the Euro”. OK…..
So I don’t think it is the convertibility of the Euro that is in doubt, but the credit rating of the PIIGS. Still, it’s only a tiny lie, as Central Bank Distractors go. So if the ECB buys those bonds, it can do it in a few different ways. It could buy them with Euros from deposits, put the Bonds in the vault, and call it done. But that would increase the supply of Euros, so be slightly inflationary while also depressing the Euro vs other currencies in Foreign Exchange.
It could sell $US reserves in the FX (foreign exchange) market for Euros and then buy the bonds. That would tend to hold the Euro up against the $US (but might have both the Euro and $US drop vs other currencies).
It could sell some other assets (like German Bunds or US Treasuries or Gold) from the vault and buy PIIGS bonds instead. That can be done in a very neutral way; but then their ‘balance sheet quality’ comes under discussion. Basically, they want to keep their gold and German Bunds more than they want PIIGS bonds… just like everyone else…
What they are doing instead is rather interesting, in an “admirable trick” kind of way…
They are having the various client banks hand over the cash to use to buy the bonds.
The European Central Bank Trick
So “Bank Of Italy” hands over 1 Billion Euros and the ECB uses it to buy €1B worth of Italian Government Bonds. The Bonds end up on the ECB Balance Sheet (but so does the €1 Billion from the Bank Of Italy as a liability) so no net creation of Euros and no dilution of their balance sheet (as they have cash to cover the bonds). One Small Problem…
The Bank Of Italy was just subject to a shakedown of €1 Billion from their “reserves”. So THEY would have to call in a load of loans (and have all that contraction of the money supply from a change of reserves in a fractional reserves system).
The ECB solution? Why, in true Central Banker Fashion, they propose to allow double counting the reserves… Yes, that’s right, the Bank Of Italy would be allowed to continue to count that “loan” to the Central Bank as part of THEIR reserves, even while the ECB is counting it as an offsetting ‘reserves’ vs the PIIGS Bonds. Gotta love it for creativity…
(Reuters) – The European Central Bank laid out plans to sterilize to its controversial government bond purchases on Monday, in a rapidly orchestrated move designed to quash fears the buy ups will lead to a surge in inflation.
The ECB also revealed 16.5 billion euros worth of bond purchases had been settled by last Friday, giving markets their first true glimpse of the ECB’s contribution to a $1 trillion attempt to resolve the euro zone’s debt crisis.
The ECB said it will start offsetting the purchases from Tuesday by taking one-week deposits from banks. It will offer an interest rate of up to 1.0 percent on any funds banks deposit, well above the 0.25 percent it offers on daily deposits.
“They should do another 70 billion to reach 10 percent of the total outstanding debt of Ireland: (82 bln) Portugal: (97bln), Greece: (258bln) and Spain (400 bln),” they added.
The ECB has kept details of its bond buying deliberately vague since it announced the plans last week, giving no hint on how much it will spend, how long the process could take or what type, or maturity, of bonds it is buying.
The move has received a mixed reception. Many analysts have welcomed it, pointing to the instant success it had bringing down yield spreads of trouble countries. However others, including ECB heavyweight Axel Weber, have criticized it for carrying inflationary risks.
As part of the new sterilization plan the ECB said it will allow banks to use the weekly deposits as collateral in its lending operations, a move that effectively gives them the option to reborrow the money again.
“With one hand you give and with the other you take, it’s not possible (to sterilize).. the result is still that the liquidity is there.” said ING analyst Carsten Brzeski.
The ECB said it will also repeat the operation next week and analysts now expect it to become a permanent feature.
(Reporting by Marc Jones, Krista Hughes and Sakari Suoninen; Editing by Toby Chopra)
So let me get this straight…
Instead of just creating Euros to buy the bonds, and calling the bonds assets on the balance sheet; they are BORROWING the Euros from the other banks, using that to buy the bonds and calling the bonds assets on the balance sheet: but with an offsetting liability of the other banks cash deposit; but that cash can be loaned back to the original bank (an offsetting asset) who can then continue as though nothing at all had happened?
And this is different from just creating the Euros because??…. Oh, yeah, it has a matched set of a Euro deposit and re-borrow liability and asset…
While it is an interesting bit of hand waving to hide what is really going on; I wonder how many folks will really believe this is anything other than the ECB doing a balance sheet expansion to buy PIIGS bonds? The cash still ends up in the pockets of the PIIGS governments, who will spend it, driving up demand for goods and services and increasing money in circulation (i.e. inflationary impact); and one can only hope there is enough offsetting deflationary stress from the economic slowdown that the two stresses balance… The client banks have “no net effect” other than a matched set of ‘loan – reborrow’. The ECB still has net Euro issuance (that ‘re-borrow’ OR the PIIGS bond buy, depending on which one you choose for the assignment) and their is still an increase in Euro Deposits.
At best, it puts the ECB on the hook for the PIIGS bonds instead of retail banks (i.e. it provides a customer for the PIIGS who can hold the bonds forever and doesn’t really ever need to cash them out as it can just create Euros as it needs them) and dilutes the ECB balance sheet quality. It can lower the cost of borrowing by the PIIGS (but raise the risk for those loaning to the ECB…) It swaps “good faith and credit” of the ECB for that of the PIIGS while having the various Euro Retail Banks entangled with the process as smoke screen.
I’m having a real hard time finding how this “sterilizes” the Euro vs any other currencies as it does not act in the FX markets and it does create more Euros (just depending on the various banks to ‘re-borrow’ rather than direct ECB issuance). It is, in effect, a reduction in the reserves requirements on client banks of the ECB (by the amount of the deposits at the ECB). That is typically thought inflationary and not an FX activity.
But it is a creative way to “change the definition”…