DRAGHI´S REMEDY MUST NOT BECOME A PANACEA / THE FINANCIAL TIMES MARKETS INSIGHT ( A MUST READ )

Markets Insight
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April 19, 2012 6:09 pm
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Draghi’s remedy must not become a panacea
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By Pierre Lagrange

Quantitative easing is a magic remedy, at least in the short term. Central bankers can conjure up money out of thin air and use it to purchase assets. Such activity has the capacity to transfer toxic debt, stimulate demand for risk assets, devalue currencies – thus deflating debt – and maintain low interest rates on government securities.



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The European Central Bank’s more restrictive mandate does not allow it to print money for any other purpose than lending, so QE is out of the question. Mario Draghi can therefore be said to have demonstrated the new resolve of the central bank under his leadership in unveiling his longer-term refinancing operation programme within eight weeks of taking office. As we have seen in the case of Hong Kong in 1998 and Switzerland in 2011, decisive central bank intervention sends a message to the markets that there is a willingness to do whatever is necessary.

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Conversely, earlier ECB bond purchases were an indication of wobbly resolve which caused the markets to gorge on negativity. LTRO has therefore transformed a soft belly into a six pack, but more exercise is needed.

 

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Structural issues that are key to longer-term survival need to be addressed while the artificial support of central bank liquidity is in place. Otherwise LTRO will simply prove a case of throwing good money after bad.

A further aspect of LTRO is that it ingeniously makes use of the Basel II accounting rules which place a capital charge of zero on the debt of sovereign nations in the European Economic Area.



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Consequently, the ECB can lend unlimited quantities of funding to European banks, at a nominal interest rate, knowing there is more than one incentive for these banks to purchase government debt.


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Firstly, they can make easy profits from capturing the differential between the interest charged on the borrowed money and the yield on the government debt. Secondly, they can bolster their balance sheets from a regulatory perspective. Moreover, the banks help achieve one of the critical aims of QE in maintaining low borrowing costs for indebted governments.



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Furthermore, LTRO has provided a timely boost to banks in their attempts to raise capital to satisfy an increasingly penal regulatory agenda. The launch of the programme came just four days before the deadline for banks to submit plans for raising the cash needed to maintain capital adequacy levels.



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In providing a temporary resolution to the critical issue of liquidity, LTRO afforded us the opportunity to take a much more structural view of bank fundamentals and pricing dislocations. We have therefore been able to invest with a degree of conviction and to size positions in accordance with proximity to objective target prices.




Nevertheless, a boost in liquidity, like most pharmaceutical drugs, only works effectively in conjunction with complementary measures. Apart from the examples of UniCredit, whose rights issue had been decided before, and Sabadell, we have seen little equity capital raised. This contrasts with the example set by the US in March 2009, which used the Fed-inspired rally to launch gazillions of equity. Central bankers will be again solicited to control markets, testing governments’ resolve.



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In terms of further LTRO usage, we envisage trouble from the fact that most Spanish debt raised has been bought by domestic banks, and that cross border confidence has not been boosted for long.


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Indeed, the data suggest that foreigners have used this window to divest from Spanish government bonds, and the domestic banks have been left mopping up the inventory, albeit with an attractive carry.


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There is increasing evidence that most of the monies from the LTRO have been spent or earmarked, more quickly than the markets thought. Central bankers will soon find themselves needing to buy government debt in the secondary market to prevent rates rising excessively in the periphery. How they do it and what it leads to is important. There is a variety of tools they can use, from securities market programmes (SMP) to relaxation of haircuts. They can also allow Spanish banks to issue government guaranteed debt, essentially creating ECB eligible collateral, similar to what Italian banks have been able to do. SMPs were stopped after the LTRO, but can be reactivated, we hope sooner rather than later. Markets need to understand central banks will not let rates spiral out of control.


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This summer has the added volatility of important elections in Europe, as well as distractions from football to the Olympics, that increase risks of spikes on low volumes. Market interventions will need to be more stringent as a consequence.



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Theoretically there are few limits to what the ECB can do. We will test market limits as investors look through temporary fixes, and political limits such as how much money the ECB can effectively create. This will test the resolve of politicians and central bankers from the north.



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Pierre Lagrange is a co-founder of GLG, chairman of Man in Asia and a portfolio manager



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Copyright The Financial Times Limited 2012.