Macro Weekly – How far can central banks go?

by: Han de Jong

Big Picture - 10 November 2014 - How far can central banks go?.pdf ()

Alleged dissent within the ECB has dominated the economic and financial news recently. It seems the ranks have been closed, at least for now. The ECB is going ahead with aggressive further easing. We think that the compromise reached was not to go ahead with sovereign QE, at least for the time being. Economic data released in the week just gone by was generally constructive in the US, but mediocre elsewhere.

Leaks to the media suggest that there is dissent in the Governing Council of the ECB. That is not good. The intensity of the crisis is much lower than it was in 2011, but central bankers can certainly not rest on their laurels yet, nor can other policymakers. They must continue to show determination and resolve, rather than in-fighting. The eurozone economy is weak and looks vulnerable. Inflation has undershot the ECB’s target for almost two years and is now so low that one has to say that we are just one shock away from deflation. While a period with negative inflation is not the end of the world, the ECB cannot ignore the risks.

I have recently been confronted several times with the question how far central banks can go extending their balance sheets. The US Fed has boosted its balance sheet from below USD 1,000 bn before the crisis to some USD 4,500 bn currently. The ECB’s balance sheet totals some EUR 2050 bn. Apparently, the ECB is planning to increase the size of its balance sheet to some EUR 3,000. This represents a remarkable increase in leverage as they are, to my knowledge, not planning to raise additional capital. Commercial banks have just gone through the Asset Quality Review and the ECB stress test. Discussions about the minimum leverage ratio are ongoing. For now the minimum is 3%, but it looks likely this will be raised. Big UK banks will, most likely, be required to have a minimum leverage ratio of 4.05%, with the possibility that this will be raised to almost 5% depending on the business cycle.

The question some clients have asked me is if central banks comply with the same rules. The short answer is: no and that it does not matter. At the end of July, the US Fed held USD 56 bn in capital, against a total balance sheet of USD 4407, implying a leverage ratio of 1.3%. The ECB had EUR 95 bn capital as of 26 September, against a balance sheet of EUR 2038 bn, for a leverage ratio of 4.7%. If the ECB were to lengthen its balance sheet by EUR 1,000, its leverage ratio would drop to 3.2%.

While it is perhaps interesting to look at these ratios and see them move, I think they are completely irrelevant. A central bank is not a normal company and certainly not a normal bank. A leverage ratio is a solvency measure. It is an indication of the size of losses that can be absorbed by capital. There is one huge difference between the balance sheet of a normal bank and of a central bank. A central bank has a liability item that represents debt that will never be redeemed and over which the central bank does not pay interest. In case you are wondering who, on earth, gives a central bank a perpetual, zero-interest loan, I must disappoint you: we all do. Currency in circulation effectively is an interest free loan we give to the central bank and nobody considers asking for their money back. We are a great creditor to have. In the eurozone, currency in circulation amounts to EUR 970 bn, that is almost half of the ECB’s balance sheet. In the case of the US, currency is USD 1,307 bn, or almost 30% of the Fed’s balance sheet. The Fed is a more leveraged institution than the ECB: that much is clear.

If you consider an interest-free, irredeemable liability capital, then the capital position of these central banks is very strong and they could leverage up much further. But that does not really answer the question of how far central banks can go. I suppose the real answer is that central banks can go as far as we let them. That is to say, as long as the public continues to have confidence in the integrity of the financial system. Nobody knows where that confidence ends, but there are no signs that that confidence is eroding to any serious degree. Having said that, I guess it is not wise for central banks to try and live on the edge. It is probably a binary situation, confidence is either there or it isn’t. A change from ‘confidence’ to ‘no confidence’ might be very abrupt.

That is all theory

What is important for now is that the ECB is following a relatively aggressive course in their asset purchases. Our covered bond strategist, Joost Beaumont, estimates that the ECB has recently bought up to a third of new peripheral covered bond issues. So the ECB is not afraid to own relatively large chunks of a particular issue.

In his press conference last Thursday, ECB President Mario Draghi made it clear that it was not a slip of the tongue when he said earlier that the ECB wishes to expand its balance sheet towards the level it was at in 2012 and clarified he was referring to March of that year. That is serious business.

Many commentators believe that the ECB will engage in buying government bonds. They may be right, who knows? But we still feel that it is tricky for the ECB.  Other than size, it is not obvious what the ECB has to gain from buying government bonds instead of other assets, while the downside is that it is very controversial, particularly in Germany. A more logical approach would be for the ECB to see if they can get the size they want in the other debt securities markets and only engage in government bond buying if they can’t get enough satisfaction elsewhere.

Economic data

Economic data releases were unexciting this week. Measures of October business confidence were mostly weaker in emerging economies than in October. On the other hand, the US ISM was very strong, rising from an already firm 56.6 to 59.0. This level was last exceeded marginally in 2011 and before that in 2004. US initial jobless claims were also better than expected at 278,000 last week, continuing their downward trajectory, indicating a further improvement in the labour market. But US payroll numbers disappointed a little. 214,000 US jobs were added on a net basis in October, a little shy of expectations, though the previous two months were revised up somewhat. This data is no reason to change our view that the US economy is doing relatively well and continuing to recover at a pace that is above its long-term potential.

The week was light on eurozone economic data. The most closely watched were probably German industrial orders and industrial production for September. Both series had fallen sharply in August, when orders were down 5.7% mom and production 4.0% mom. This was blamed on the unusual pattern of holidays with many more people than usual taking holidays in August. A solid rebound was expected, assuming the holidaymakers came back to work. The data disappointed, although one has to bear in mind that this data can be volatile and is prone to revision. Actually, the terrible August data was revised up. Orders were down ‘only’ 4.2% mom in August, instead of the originally reported drop of 5.7%. But even against this revised number, the 0.8% mom gain in October was a disappointment. Industrial production did a little better, gaining 1.4% mom after a revised decline of 3.1%, which was originally reported as -4.0%. What can we say? Germans get very good holidays. Perhaps some of them did not come back yet in September. Let’s wait for the October data. It still seems to us that the factors that should be decisive for the future trajectory of the economy are suggesting growth should pick up before too long.