Excess liquidity in the eurosystem – a problem of own making

Just in 5 years, the European Central Bank (ECB) has inflated its consolidated balance sheet, bringing it from €2.2 tn in early 2015 to €5.3 tn at the end of March 2020, through unconventional monetary policy. Quantitative Easing (QE) in the euro zone truly started in March 2015, when the public sector purchase programme (PSPP) began, supplemented by a corporate sector purchase program (CSPP) in June 2016. These programmes were added to the asset-backed securities purchase programme (ABSPP) and the third covered bond purchase programme (CBPP3). On 18 March 2020 the ECB’s Governing Council announced a new pandemic emergency purchase programme with an envelope of €750 billion. These programmes are part of the ECB’ umbrella Asset Purchase Programme (APP). In addition to the main refinancing operations (MROs), non-standard measures in the toolbox of the ECB also include 3-year long-term refinancing operations (LTROs), pandemic emergency longer-term refinancing operations (PELTROs), up to 4-year targeted longer-term refinancing operations (TLTROs).

Quantitative Easing focuses on the quantity of bank reserves, which are liabilities of the central bank. Quantitative Easing can be implemented through the use conventional open market purchases to acquire longer-term government securities instead of the short-term bills that central banks normally buy (buy one of the risky and/or less-liquid assets). Another method is to reduce risk or liquidity spreads (paying either by selling some Treasuries from the asset portfolio or creating new base money). The effectiveness of either methods of QE depends on the degree of substitutability across the assets being traded. A third method is to provide liquidity to financial institutions through refinancing or purchase of securities. A special case is Credit Easing which focuses on the mix of loans and securities that the central bank holds and on how the composition of assets affects credit conditions, reducing real interest rates and raising asset prices.

At the end of the first quarter of 2020, the stock of ECB’s securities holdings acquired through these programmes reached €2.8 trillion, largely in the form of securities issued by the public sector (about 2.2 trillion). According to the ECB, these asset purchases support economic growth across the euro area and help return to inflation levels below, but close to, 2%. Generally, the empirical evidence of strong stimulating effects and higher inflation is however ambiguous. Nevertheless, positive results have been achieved in supporting provision of liquidity to the corporate sector through capital markets, according to the ECB, which also sees the APP as persistently having reduced euro area long-term bond yields, both of targeted and other debt securities, while boosting equity prices via the signalling channel. On the other hand, the APP has led to capital outflows, mainly for the purchases of foreign long-term debt securities by non-euro and euro area investors (in particular investment funds and households). This expected re-balancing, notably after the scale up of the PSPP in June 2016, has been made with important differences across countries.

The two most prominent transmission channels of Quantitative Easing are the signalling – reduction of expected short-term interest rates – and the portfolio re-balancing channels. Both are mainly targeted at lowering long-term interest rates, flattening the yield curve and increasing asset prices. On formally adopting the “yield curve control (YCC)”, Christine Lagarde, President of the ECB, said “the combination of tools that we are using at the moment enables us to operate across the entire curve and to actually deal with all maturities”. The Bank of Japan’s “yield curve control” initiative was launched to anchor longer-term rates near zero in a bid to more directly influence consumer borrowing costs and spending. Most probably, the reason why YCC is a no go for the ECB is that there is no common euro-area bond it could buy.

Though the Outright Monetary Transactions (OMT) programme, announced in August 2012, was a huge success in bringing down the high bond yields in the peripheral euro nations – especially Greece, Ireland, Italy, Portugal, Spain – and its effects equivalent to that of a large-scale asset purchase programme, it was never activated before the Coronavirus pandemic and its activation today is uncertain. In this regard, Christine Lagarde said “We are facing a situation where it’s not a single country, but it’s all countries, where it’s a global shock that applies in a very symmetric way. The best tool that we have in our toolbox is indeed the PEPP”.

German Chancellor Angela Merkel is now in favor of issuing EU bonds, but she remains skeptical toward the idea of a broader pooling of debt risk. Moreover, opposition to the so-called corona bonds from Germany and some other countries remains strong. Though, such bonds would make it possible for the ECB to exit from Quantitative Easing. Measures of Quantitative Easing bear risks via unintended consequences, including the creation of “zombie companies”, asset-price bubbles, riskier lending behaviour from banks, etc. The Eurosystem’s exposure to financial risk as a whole has increased, as many have underlined (Donnery et al, 2017). The exit from low or negative interest rates and Quantitative Easing may be extremely difficult, notably when the balance sheet is extremely large, which is the case of the consolidated balance sheet of the ECB. Christine Lagarde said “Yes, we are looking at the exit options”, but she did not provide more details about possible options and consequences.

Tightening of monetary policy would contribute to a sovereign debt crisis and possibly financial market distress. The creation of EU bonds would make it possible to swap public securities held by the ECB and EU bonds and eventually to conduct YCC if and when desirable. The increase (€3.1 trillion) in the size of the euro zone consolidated balance sheet over the period from the end of 2014 till the first quarter of 2020 has inflated the size of monetary policy instruments (e.g. current accounts, deposit facility). It has also led a significant increase in the size of the balance sheet autonomous factors and of the banking sector liquidity. At the end of March 2020, the amount of autonomous factors stood at € 2.8 trillion. Besides currency in circulation, holdings at central banks by non-financial institutional clients (e.g., governments) are a main driver of autonomous factors in the Eurosystem.

The amount of excess reserves ballooned to about €2 tn at the end of March 2020. On the asset side of the ECB consolidated balance sheet, the amount of policy assets (lending to euro area credit institutions related to monetary policy operations and securities of euro area residents denominated) was about €1.7 tn higher than the excess liquidity. The winding-down of excess liquidity is thus a remote prospect. Experts, including the IMF, are warning that unwinding Quantitative Easing could cause a super taper tantrum, with increased volatility in the markets and a fight for liquidity.

Whenever, the monetary policy normalises – presumably gradually -, liquidity will become scarcer, which could cause inter-bank rates to drift above the deposit facility rate, depending on the autonomous factors demand which are not under the ECB’s control. In fact, a high sell-off of securities held by the EBC will lead to liquidity crunch. Moreover, the adequacy between demand and supply of liquidity will be challenged by the current excess liquidity that is highly concentrated in five eurozone countries and among the area’s biggest 50 banks. The other banks that rely heavily on excess liquidity to meet the Liquidity Coverage Ratio (LCR) requirement might face problems, which could have financial stability implications, likely upward pressures on interest rates and possibly lower growth.

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