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by Economist

THE European Central Bank (ECB) tends to take the long way around. When in 2009 the Federal Reserve and the Bank of England slashed interest rates towards zero and started quantitative easing (buying government bonds with central-bank money), the ECB was more circumspect. It was reluctant to cut its main rate below 1% and loth to buy government bonds directly.

Instead it adopted its own non-standard measures. It offered unlimited loans to commercial banks for up to a year against a broad range of collateral. The ECB’s oblique approach had much the same effect as the route taken by the Fed and others. A flood of liquidity from a €442 billion ($611 billion) auction of one-year ECB loans in June 2009 pushed short-term interest rates close to levels in America and Britain. Banks used much of the cash to buy government bonds, driving down long-term interest rates.

More than two years on, and in far more trying circumstances, the ECB seems to have repeated the trick. Faced with renewed recession, a bank-funding crisis and investor revulsion against all but the safest euro-zone government bonds, the ECB said on December 8th that it would provide unlimited funds for 36 months at its main interest rate (which it cut to 1%), at two auctions. The first of these, on December 21st, attracted bids of €489 billion. That more than matched the amount lent for one year in June 2009, and has had similar effects. Overnight interest rates have fallen to around 0.4%, well below the ECB’s benchmark rate. Longer-term bond yields for investment-grade euro-zone countries—ie, everyone but Cyprus, Greece and Portugal—have dropped, too (see left-hand chart).

The decline in short-term rates is not surprising, given the excess liquidity washing around the euro-zone banking system: banks have almost €500 billion on overnight deposit with the ECB earning interest of 0.25%. A fall in longer-term bond yields looked less of a sure thing when the two auctions were announced. Borrowing money from the ECB for three years at 1% to buy bonds with much higher yields might look an obvious carry trade. But it seemed that only the bravest or most desperate banks would want to risk loading up on government debt issued by Italy or Spain so soon after being told by the European Banking Authority (EBA) to raise capital against declines in the value of that very debt. Even so, ten-year Italian bond yields have dropped by around one percentage point so far this year, to below 6%; Spanish yields have fallen sharply, too.

The rally in bond prices may be as much to do with a change in expectations as with the direct use of the three-year money in bond purchases. The ECB says that the net increase in liquidity owing to the December auction was a more modest €193 billion, because banks retired some shorter-term loans at the same time. They have done more of the same since then, which means the incremental increase in liquidity is closer to €150 billion, says Laurent Fransolet at Barclays Capital. Perhaps two-thirds of that total was raised to replace bank bonds that are set to mature soon, he reckons, and only a third to finance carry trades. That is a fraction of the total the ECB has spent since the summer, trying in vain to cap bond yields of peripheral countries.

Yet the headline number of €489 billion and the promise of a second (potentially larger) three-year auction later this month have been enough to turn sentiment around—especially as non-bank investors had started 2012 short of euro-zone government paper. Before the end of the year “everyone was underweight Italy because they were worried about being fired for being long,” says the head of capital markets at one large investment bank. “Now the job risk has shifted to being underinvested in Italy.”

Banks may also be more inclined to use the February auction to finance sovereign-debt carry trades following assurances from the EBA that it will not mark down the value of government bonds in its next round of stress tests. “The test was a one-off,” says one senior EBA official. Several banks say that they have had similar encouragement from regulators. “We’re going to use it,” says the boss of one large bank in a peripheral country, of the ECB facility. “It doesn’t matter if we buy government debt with public money, or the ECB buys it directly. It has exactly the same result.”

Fringe benefits

So the ECB seems to have stopped the rot. Banks have secure financing for three years, which has militated against the risk of a liquidity shortage that could lead to bank failures. A run on illiquid but solvent governments has been halted.

But this being Europe, a host of worries remains. Banks are still required to meet the minimum capital ratios set by the EBA by June 30th. Since equity is hard to raise, banks have to marshal their existing capital carefully, which will make loans for consumers and firms hard to come by. A worrying sign that recession may linger is that euro-area bank loans to the private sector, as well as bank deposits, fell sharply in December (see right-hand chart). The ECB’s quarterly bank-lending survey on February 1st reported a substantial tightening of credit conditions. Banks also expect to tighten credit standards over the next three months.

Bond purchases will leave banks at greater risk if anxieties about public solvency return. The more banks pledge collateral to draw on long-term ECB financing, the less attractive it is for investors to buy banks’ unsecured bonds, as they will be further behind in the queue in the case of bankruptcy. The issue of “addiction” to ECB funds is particularly acute in the peripheral countries that need to finance large current-account deficits (and to refinance accumulated deficits) through their banks.

That helps explain why Portugal has not shared in the rally. Investors fear that it, like Greece, may not be able to repay its public debts. If negotiations over private-sector losses on Greek government debts end in a coercive deal or a messy default, the appetite for other risky euro-zone debt could also fade. The ECB may yet be forced to take the direct route to bond-market stability.