Some Thoughts On The ECB/Fed Announcement

By Win Thin

Today’s announcement that the ECB has coordinated with the Fed to give unlimited US dollar access to European banks through year-end was taken positively by markets. The euro strengthened and equities rallied. Clearly, this was something that was agreed to at last week’s G-7 meeting, but we would downplay the coordination aspect since this is very low-hanging fruit in terms of coordinated policies. Fed swap lines with the world’s major central banks are already in place, and so we wonder how much added impact this new one will actually have. Still, it has helped boost sentiment and these days, that accounts for something.

There are several ways to look at this, but we think that the main aim of this measure was to address and perhaps avoid year-end stresses in the European banking sector. There are concerns that a year-end squeeze could end up being destabilizing and so are trying to be proactive. We know two European banks have been forced to go to the ECB to get dollar funding totaling $575 bln last week. Metrics such as euro basis swaps have shown increasing funding stresses for European banks.

The Fed may have some domestic considerations behind providing dollar liquidity to European banks. Presumably, much of the dollar funding needs stems from European banking activity in the US itself, typically corporate lending to US companies and/or US branches of European companies. If dollar funding to the European banks is cut off suddenly, that would lead to curtailed loan activity. Given how weak the US economy is right now, we think the Fed is cognizant of the spillover risks from a European banking crisis and will take preemptive measures whenever possible. Providing dollar funding appears to be a low cost option.

We would downplay talk that this is preparatory work ahead of a Greek default. While that default is still our base case, we believe that Greece has taken sufficient measures to get approval from the troika to receive its next tranche of aid. In that case, Greece appears able to muddle through for the rest of this year, which is exactly the period that is being covered by these new liquidity measures.

But thinking ahead, there are reports that the German banks are talking about a Plan B in case Greece defaults. Why wouldn’t the world’s central banks also be working on a Plan B? Spain’s Finance Minister Salgado today confirmed that “new recapitalization” is being discussed in Europe, and this would have to be a major component of any Plan B.

This latest dollar funding scheme addresses the symptoms but not the illness. The illness is that Greece is insolvent, and one of the symptoms is that banks are afraid to lend to each other and are instead hoarding cash. Today’s actions won’t PREVENT a Lehman-type event (Greece is insolvent, period), but they could MITIGATE the dislocations and market turmoil that will likely result from such an event. We fully expect policy-makers are preparing quietly for a Greek default, and would look for more and more preparatory measures in the coming months.