• Reports have emerged that the ECB is considering introducing a two-tier deposit rate system…
• …it would cushion the blow to bank profits, while potentially allowing the central bank to cut rates more significantly
• New left-wing minority government in Portugal darkens the outlook for government finances
Rumours on ECB discussions
With the ECB Governing Council meeting approaching next week, speculation continues to build about the package of measures that the central bank will announce. Reuters quoted ECB officials – on condition of anonymity – who gave an ‘update’ on the state of play on the discussions in the Governing Council.
Governing Council still looking at various options
One ECB official was saying that the Council was ‘still trying to figure out what will be in the package. A lot of people have different views’. This suggests that the ECB is still exploring a variety of options, with no clear consensus yet. One option that has already been mentioned before, is the inclusion of regional bonds to the eligible universe, which seems a very logical step given the likely stepping up of QE. In addition, some new elements were also mentioned, most interestingly, a two-tiered deposit rate.
Two-tiered deposit rate idea under review
As far as we can tell from the quotes, the idea would be to charge banks a different deposit rate depending on what level of excess liquidity they deposit. For instance, commercial banks that deposit a relatively low level of funds would face a less negative deposit rate, while those that deposit more funds would face a more negative one. Core banks tend to use the deposit rate facility the most, so they might be most affected by a more negative ‘penalty rate’ for excess cash.
How the system could look
Presumably, there would need to be some scaling to take into account the size of the bank involved in order to determine the maximum a bank could deposit at the more favourable rate. For instance, a fixed percentage of the bank’s total customer deposits, or total assets.
Market impact depends on size of the corridor and amounts deposited
One thinkable scenario is that the ECB could cut the ‘main’ deposit rate by 10bp to -0.3% and create a new deposit rate for funds in excess of the maximum, which could be 10bp lower at -0.4%. Essentially this would represent a middle ground between cutting the deposit rate by 10bp and 20bp.
The impact on interbank rates and short-end bond yields would somewhere be between a ‘pure’ 10bp and 20bp deposit rate cut. This would depend on which of the dual rates will be most important in terms of the amount of funds that are deposited. Compared to a ‘pure’ 20bp deposit rate cut, the market impact on interest rates and therefore currencies would therefore be less. However, the ECB could also go for a more aggressive reduction in the new deposit rate for high levels of reserves. For instance, it could be set at -0.5%. Then the actual impact on market rates would be between a 10bp and a 30bp reduction, making it more equivalent to a ‘pure’ 20bp reduction of a single deposit rate.
Advantages and disadvantages
The advantages of the dual system are that it would cut banks that do not deposit ‘too’ much liquidity at the ECB with some slack, in the sense that they could continue to deposit their funds at a lesser negative rate. It would therefore cushion the blow to bank profits, while still delivering a bigger rate cut. By doing so, the ECB could keep the euro under pressure. The disadvantage is that the system would become more complex.
Bond market reacts positively on two-tiered deposit rate
The bond market digested the possible introduction a two-tiered deposit rate instantly. The yield on the German 10 year bond dropped by 2 basis points to below 0.47%. Also yield spreads between euro area countries compressed. The difference between 5 year Spanish and German bonds decreased for instance by more than 4 basis points.
New left-wing government in Portugal raises probability of fiscal slippage
Meanwhile, Portugal’s President, Anibal Cavaco Silva, appointed the leader of the Socialist Party Antonio Costa as the next prime minister. He will lead a minority government that will be supported in parliament by the more radical left-wing Left Bloc and Communists. According to Portugal’s president, Mr Costa has pledged that he will stick to the EU’s fiscal rules, but this seems to be in conflict with some of the points in his policy programme. For instance, he wants to reverse some of the cuts in civil servant salaries, pensions and public services and some of the tax rises that have been implemented in recent years. Besides that, the EU’s fiscal rules have clearly loosened significantly in recent years, having introduced the possibility of a trade-off between austerity and deficit reduction on the one hand and economic reform on the other hand.
Overall, there seems to be a significant possibility of fiscal slippage. According to the recently published Autumn 2015 Forecasts by the European Commission, Portugal’s budget deficit will fall from 4.5% in 2014 to 3.0% this year, but we think a decline to a little below 4% is more likely. This means that the outlook for Portugal’s high level of government debt is less positive. According to the EC, the debt ratio probably peaked at 130% GDP in 2014 and should decline to 128% this year, to end up at 121% in 2017. We think it will fall much more moderately, while the risks are rising that debt will merely stabilise.