Wednesday, July 22, 2009
Money struggles to pass through banking pipe
--Money pumped by ECB to Commercial banks ended up in ECB's balance sheet, banks deposits --Some money funneled to government bonds, corporate bonds, to financial system. It might distort the market without benefiting real economy where it needs money most --The blockage of banking pipe is not unique to Europe. Japan QE in the lost decade encountered the same issue. By David Oakley, Ralph Atkins and Gillian Tett Published: July 21 2009 18:55 Last updated: July 21 2009 20:46 Central banks have pumped a vast amount of money into the financial system this year – but so far there is little evidence that this liquidity has found its way into the broader economy. What is happening could be likened to the pattern that develops when a household drain is partly blocked as the central banks frantically pour money into the financial system, with the commercial banks supposedly acting as a pipe, in an effort to stabilise the economies. But many commercial banks are reluctant to pass this liquidity on to their customers, in the form of loans, because they are scrambling to repair their own balance sheets and are afraid to lend because of fears of potential losses. The banking pipe is, thus, partly blocked. So where is this money, or liquidity, ending up? At the moment, a large amount is being parked at the central banks themselves. In Europe, commercial bank overnight deposits at the European Central Bank have soared since the ECB pumped €442bn in one-year loans into the system on June 24. Although the amount of money deposited overnight is very volatile, it rarely went above €50bn before the ECB injection. On Monday night, it stood at €188bn, and it has surged above €300bn on some days this month. Jean-Claude Trichet, the ECB president, has warned that “it may take some time ... for the extra liquidity to be transformed into credit” – without specifying how long. He has also acknowledged that much of the €442bn financial injection is being parked at the ECB’s overnight deposit facility. “Banks will have to gain experience in using the longer-term credit that they obtain from their central banks to expand their longer-term assets rather than increase the availability of short-term liquidity,” Mr Trichet says. In the nearest the French ECB president comes to a headmasterly telling off, he adds: “We remind banks of their responsibility to continue to lend to firms and households at appropriate rates and in suitable volumes.” Deposits have also risen sharply at the US Federal Reserve and the Bank of England. As well as depositing money at the central banks, the commercial banks are also buying government bonds, high-quality corporate bonds and, of late, equities – in effect recycling the liquidity around the financial system. While this “backflow” of liquidity is not dangerous yet, some economists fear it could end up distorting the markets in the coming months – undermining the rationale behind the extreme monetary measures. Some hints of this “backflow” emerged when Deutsche Postbank received €9.2bn of offers for its debut public sector covered bond on July 3 in the space of just 10 minutes. In the end, it sold €1bn to investors, of which about €300m was sold to banks. This buying of bank bonds by the banks themselves appears to fly in the face of what the monetary authorities are trying to achieve, although investors say using spare cash to buy financial debt is safer than making loans since the banks are tacitly guaranteed by the government. Mike Amey, head of UK bond portfolios at Pimco, says: “It makes sense for investors to buy senior bonds issued by the major UK banks because they are relatively safe, with high levels of government support, and offer significant extra yield over government bonds. For example, you can buy five-year RBS bonds for a yield of 5.7 per cent compared with 2.9 per cent on a five-year gilt.” This blockage in the banking pipe – or “broken transmission mechanism” to use the monetary jargon – is not unique to Europe. It was a crucial issue that bedevilled the Japanese in the late 1990s and early part of this decade when the Bank of Japan engaged in quantitative easing at the time. In particular, when the BoJ flooded the markets with liquidity, the banks tended to hang on to that cash, rather than turn it into loans, even when the government pleaded with them to pass the monetary aid on. That, in turn, distorted the Japanese money markets and left some Japanese officials quietly concluding that QE had not been very successful. In the UK, the Bank of England has tried to circumvent that problem – and learn from Japan – by purchasing gilts, rather than giving money directly to banks. The theory is that asset managers might use the cash they receive to purchase corporate bonds, driving down their yields. In essence, the British are using a tactic akin to trying to shove liquidity through multiple pipes, in the hope that some of it gets to the economy – even if one or two pipes are blocked. The key question is whether the extraordinary central bank policies are working. In the case of the eurozone, bank lending to non-financial corporations – one of the most important barometers to the success of the ECB’s actions – has slowed dramatically this year to an annual growth rate of 4.4 per cent in May from a rate of 9 per cent in January. Eurozone lending for house purchases contracted by 0.5 per cent in May. No wonder central bankers are watching the situation closely. As long as some of the liquidity is still passing through the system, irrespective of the blockages, then the extra liquidity can have a stabilising effect. However, the risk of “backflow” is prompting unease and may be one reason why central banks end their current policies sooner than some expect.