Thursday, Jan 12, 2012
By Javier E. David
Of DOW JONES NEWSWIRES
NEW YORK (Dow Jones)--The European Central Bank's increasingly swollen balance sheet has helped calm volatile markets, but some believe it could itself become a problem and bring more volatility to the 17-nation currency bloc.
Nearly a year's worth of anticrisis lending measures have sent the ECB's books to a record EUR2.73 trillion, some 29% of the euro zone's gross domestic product. This expansion, capturing both the collateral pledged by banks receiving funds from the central bank and the sovereign bonds it has purchased for its own account, has been welcomed by bond investors, who see it as a stabilizing force. But the excess liquidity bodes for a weaker euro, and has some wondering if the ECB's own solvency could eventually be in peril.
Exactly how exposed the ECB's financial position is to euro-zone contagion is a point of dispute.
The central bank's securities holdings from outright purchases are large but relatively manageable. Of the ECB's estimated EUR211 billion in euro-zone periphery holdings, only Greek debt -- about 17% of that total -- is seen in the most immediate jeopardy.
Still, a solution to restructure Greece's mammoth debt load has proven elusive, and many investors are concerned that a default in the Hellenic republic could ricochet across the 17-nation currency bloc. That could renew an assault on other euro-zone bond markets that are already distressed.
More worrisome are relaxed collateral rules. When the ECB introduced a three-year tender last month at generous 1% interest rates, more than 500 banks gorged themselves on a record EUR489 billion of the central bank's cash. Some commentators worry that a worsening of peripheral bond markets could endanger securities pledged by the banks, posing a considerable solvency threat to the central bank.
"The quality of the balance sheet deteriorates as it expands, which is doubly problematic," said Michael Woolfolk, senior currency strategist at BNY Mellon in New York.
Aside from asset quality concerns, there is a weakening effect to the euro itself from interest rate cuts and what Woolfolk says is a Federal Reserve-style "quantitative easing" program in all but name. "Any form of monetary easing is corrosive to the currency," Woolfolk said.
Still, ECB defenders insist that its primary form of monetary expansion cannot be equated with quantitative easing. Unlike the Fed, the ECB is not making large-scale bond purchases that permanently increase the money supply. By definition, its three-year refinancing operations are temporary, which doesn't leave excess liquidity sloshing around the financial system for long.
Yet over that period, the ECB will be sitting on securities that some observers believe to be of questionable quality. Should the central bank's balance sheet come under serious threat, the euro could also suffer the consequences.
Recent ECB rule changes expanded the type of debt banks can post as collateral -- including, in some cases, non-investment grade bonds. Because the crisis has triggered a rout in bond markets and a rash of credit downgrades, some analysts worry that banks have offloaded poor quality paper to the ECB, especially in the wake of December's record tender.
"There's obviously some question of whether or not enough [quality collateral] has been posted," said Aroop Chatterjee, chief quantitative strategist at Barclays Capital in New York.
The ECB applies a "haircut" to the collateral it takes in--lending less than the security's face value--but it's unclear if that method has protected its portfolio from deteriorating market values. Of special concern are its holdings of Greek debt, which have been hit especially hard during the crisis.
Marking the ECB's debt holdings to market value, Barclays estimates that its losses on Greek debt could be somewhere north of EUR25 billion. For now that's a modest sum, but it could be larger if there are writedowns from a future restructuring or default. Barclays called the possible losses on ECB Spanish and Italian debt "relatively benign."
Furthermore, many believe that governments, knowing the crucial importance of a solvent central bank, will help it out. Andrew Busch, global currency and public policy strategist at BMO Capital Markets, says there "has to be some sort of tacit approval that the ECB will be made whole on losses from sovereign buys."
-By Javier E. David, Dow Jones Newswires; 212-416-4564; javier.david@dowjones.com
(END) Dow Jones Newswires
January 12, 2012 16:53 ET (21:53 GMT)
