So, what did the ECB do again?

What happened over the year end and its implications for UK economic policy

When the Eurozone countries agreed in the autumn new measures to support European banks, few realised how significant these measures might prove to be in practice.  As the year end approached there were media reports that liquidity in the banking system might be under strain.  However the European Central Bank began its Longer Term Refinancing Operation (LTRO).  This was worth €489bn - ie large (the Financial Times reports that banks are keen to take part in the second round).

So, how did it work?  Well, European banks pledged assets (mortgate backed securities etc) to the ECB as collateral in return for which they borrowed cash for three years ie they were able to convert illiquid assets for a liquid asset (ie cash) at a relatively low interest rate.  The ECB required a margin on the collateral assets ie it valued them at a discount.  The banks then used the money in large part to buy sovereign Eurozone bonds.  If we were to chart Italian bond yields for example, we would see that one year bond yields rose sharply in November as people worried about sovereign and bank liquidity.  The announcement of the ECB measure seems to have had a profound effect, with one year Italian bond yields falling (it's assumed that banks were buying them).

The policy implications are that this appears to have taken some of the crisis pressure off Eurozone governments and given them more time to resolve the financial problems; without short term fears of a bank getting into liquidity-shortage trouble.  For example, it means that there has been some space to negotiate restructuring of Greek debt (yet to be finally resolved at the time of writing).

The policy implications for the UK are not easy to establish but the avoidance yet again of an extremely deep crisis in the Eurozone is positive for growth, which in turn should be positive for the UK.  The big question at present is to what extent is the Eurozone economy slowing down, or did it just have 2 or 3 poor months at the end of last year?  The UK faces a similar question.

Stephen Beer, 31/01/2012

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