Tuesday, 26 February 2013

The Italian elections and the ECB - the big political beast

The Italian elections have already prompted all sorts of gloom scenarios. With Italian sovereign bond yields rising, the moment of truth for OMTs (outright market transactions) may be coming sooner than the ECB expected.

In what concerns the ECB, analysts usually rely on a narrative of political capture of a central bank otherwise justifiably concerned with its independence. Take for instance Michael Steen, of the FT. In his post-election analysis (Feb 25), he suggested the following:

Moreover, the fiscal conditions baked into OMT were designed after the ECB’s painful first experience of buying sovereign bonds under its so-called Securities Markets Programme. Figures released just last week showed that of the €208bn it deployed on SMP, by far the greatest share – some €99bn – went towards buying up Italian debt at a time when Silvio Berlusconi, the prime minister, was failing to implement structural reform.

This is the kind of rethoric that fits well with the German reading of the ECB actions and underplays at best, or mis-represents, the overtly political interventions that the ECB has resorted to for the past three years to push its view of necessary crisis adjustments. In other words, the ECB does no favours.

Take the first sentence. It suggests that the Securities Market Programme (SMP) came with little conditionality. That is not true for Greece - the ECB only introduced the SMP in May 2010 only after Greece agreed to IMF conditionality. Most large central banks had started outright purchases of government debt a year earlier, and without any conditionality attached! In turn, while we have no detailed ECB timeseries data on the 'nationality' of SMP purchases, we do know that the ECB sent secret letters to Ireland to push for a bailout, and to Spain and Italy to demand austerity in return for SMP purchases. In Spain's case, it even asked it to lower minimum wage regulations to address youth unemployment. The blogosphere recognizes this: Frances Coppola rightly describes is as an inept central bank that 'created and orchestrated' the crisis, and Karl Whelan's brilliant blog on the ECB risk management framework sheds further light on the political power of the ECB, so let's start treating this institution as the big political beast it is.

The second sentence is equally problematic. It implies that somewhat the ECB spent almost half of its SMP purchases on Italy and unwittingly endorsed Berlusconi's hesitant structural reforms. Again this paints the picture of a central bank caught out by political processes although a) many have linked the ECB pressure - the secret austerity letter included - to Berlusconi's resignation and b) it's impossible to tell, from the ECB data, how much of the SMP purchases of Italian debt happened once Monti came in! Furthermore, larger ECB purchases may simply reflect the relative size of the Italian sovereign bond market. At the end of 2012, the ECB held EUR bn 102 of Italian sov bonds, less than 10% of the outstanding EUR 1.673bn. 

This narrative of political capture is helpful to obscure the repo/collateral angle that gives a different account of the ECB (in)action. In my previous post, I discussed a presentation from the Italian Treasury on the role of Sovereign Debt Offices on the repo market. It confirmed that the Italian SDO does not intervene on the repo market but is considering doing so 'for the purpose of correcting dislocations in the secondary market of government bonds and improving liquidity management'. The dislocations refer to the pro-cyclicality underpinning the repo market (recognized both in the presentation and the FSB's stream on repo markets). That shows up clearly in the Italian repo market (in the graph below) , where repos traded through MTS (an electronic repo platform) have shifted from the GC (general collateral) segment used for funding to the 'special' segment typically used for shorting. So repos help amplify selling pressures, render investors more impatient and can thus precipitate a sovereign debt crisis (as LCH Clearnet did for Ireland).

Source: Cannata, 2012.

The trouble is that the Italian SDO still needs time to adjust to the unintended consequences of financial innovation cum European integration - the rapid growth in repos as instruments for shorting - while the ECB refuses to do it without conditionality. The OMT worked through signalling but that may not be enough in a crisis, and if ECB stands true to (Trichet) form, then we may see a rapid worsening of the Eurozone crisis. The good news however is that Italian sovereign debt market remains the second most important source of collateral in European repo markets, so it may be too big to fail!

The ECB is politically powerful, and has a responsability to act to preserve the Eurozone. The trouble is that it insists on austerity and labour market flexibilty as the only answers to the European crisis. The Italian elections may force it to change this very conservative stance.

Wednesday, 20 February 2013

Sovereign debt managers and repo markets

Just came across a presentation from the Italian debt management office (DMO) on their repo activity. Useful to complement my research on central banks and repo markets, and the paper I am writing with Cornel Ban on the role of private collateral managers (repo-related)  on sovereign bond markets. The presentation is based on a questionaire sent to DMOs in 18 countries, and so it adds valuable insights to the still embryonic information we have on the operation of repo markets.

1. Country differences: 

There are specific country mechanisms at play. The DMO engages directly in the repo market in most countries (AUS, DE, FI, DEN, NL, PR, Spain, UK) and through the central bank (independent from open market operations) in Brazil and the US. Australia, New Zeeland and Canada use both the DMO and central banks. DMOs in Italy, Japan and Malta do not intervene at all in the repo market for various reasons: no need (Japan), operational barriers (Japan and Italy)

First question raised here: is this a hidden form of coordination central bank/fiscal authority? What rules govern the interaction between the two?

2. Reasons for intervention:

DMOs and Central Banks carry out REPO operations for cash management purposes, to reduce market squeezes on specific bonds, to increase secondary market liquidity.

This is the interesting bit because it can indicate the extent to which the DMO can provide support to the bond market, particularly in times of stress (a la Spain) when liquidity spirals ignited by the private financial sector can threaten the liquidity of the sovereign bond market. The second and third (reduce market squeezes and increase secondary market liqudity) could both be used for this purpose.

Dissagregated data is provided: DMOs in 9 countries use repos for cash management, 5 to reduce market squeeze and 7 to increase secondary market liquidity.

Italy's DMO does not intervene in any form and so has renounced to make use of a possible stabilization tool. It should because its sovereign bond market is the second largest contributor to the European private repo market (ICMA data).

3. Types of repo:

Most DMOs engage in both special repos (using a specific asset) and General Collateral (an agreed basket). With special repos (right-hand graph), DMOs can target particular market segments, and respond to private demand for special repos that reflects high demand/shortage of a particular asset, often for trading/speculative reasons rather than for funding (the GC repo).

4. Sourcing collateral.

This is where DMOs are like no other repo market player. Private players source collateral from their own portfolios or by borrowing (sec lending). The DMO can issue ad-hoc tranches and cancel them after the repo operations: almost half of respondents do. Viewed from the shadow banking literature that treats repos like money-like instruments, there is an important parallel here: DMOs can do for collateralized financial intermediation what the central bank does for traditional banking, creating additional 'shadow' money to ease repo market tensions/shortages.This is when governments (DMOs) become central banks.

In sum, we now know more about the potential role that sovereign debt managers can play to offset the pro-cyclicality underpinning the repo market. The modus operandi across countries are very different, and some questions are left un-answered.

  • Do DMOs use haircuts/margin maintanance for repos beyond overnight? If they do, as some central banks (the ECB), then the counter-cyclical function will be diminished.
  • Can DMOs afford not to intervene where their sovereign bond market is an important source of collateral (Italy?)
  • What explains the difference between different approaches, and what are the benefits/drawbacks of coordinating withe the central bank?