Eurozone: welcome to your currency board future

Izabella Kaminska

| Mar 31 13:05

 http://ftalphaville.ft.com/2015/03/31/2125259/eurozone-welcome-to-your-currency-board-future/

 

Citi’s Chief Economist Willem Buiter spent some time with FT Alphaville explaining why he believes Draghi’s concession on profit and loss sharing among ECB member national central banks turns, in all likelihood, the single monetary unit into nothing more than a glorified currency board.
Quick background: The ECB’s profit-and-loss sharing mechanism became a key negotiating point ahead of European QE. For the Bundesbank, QE was only viable if NCBs assumed most of the responsibility for losses on assets they brought into the consolidated balance sheet. In the end Draghi acquiesced by reducing risk-sharing to only 20 per cent of assets.
A currency board works by pegging liabilities (central bank reserves and currency) to an exchange rate target, rather than a CPI or employment target. The monetary authority managing the board achieves the target by ensuring all commercial entities served by the system can convert the authority’s liabilities into foreign currency at any point. In short, there’s a guaranteed FX convertibility promise at the central bank.

The flip-side to that conversion promise is if a commercial bank wants local currency liquidity from the currency board authority, it must pledge high-quality assets denominated in the currency being pegged to. If the bank has none, it’s booted out of the system (unless it can find someone who will lend the assets to it).
The ECB, however, dishes out euro liquidity against an eclectic pool of government assets all denominated in euros, its own unit of issuance. From that point of view, the ECB’s structure is nothing like a currency board. The asset-liability exposure on its books is circular, because the ECB can always add more euros into the system to serve and support the creation of euro-denominated assets.
The system works in a circular fashion for as long as the exposures on the euro-denominated assets created by the process are pooled within the system, and profits or losses absorbed by the system as a whole. It’s a system that can never be threatened with technical insolvency. (Insolvency by inflation is a different matter — and hardly a problem in the eurozone at present.)
According to Buiter, Draghi’s decision to introduce a profit-and-loss transfer mechanism undermines this sort of positive feedback loop in the system. It turns the structure into a much more rigid currency board, with much greater risks in tow for individual NCBs.
As he noted to FT Alphaville:

For central banks, you can’t have a central bank with 19 independent profit and loss centres. Since individual national central banks have no discretionary control over their ability to print money they look more like commercial banks or sort of periphery banks in a currency board that are at risk of being forced out or going bust. The only solution to that is profit and loss sharing, as should be the case under the ECB’s own rules for actions under taken by national central banks in the pursuit of single monetary policy. And here they have declared, unanimously I think, the council, that QE is monetary policy yet there is no risk sharing. Which is bizarre in the sense that it puts the very existence of the eurosystem at risk. But it’s also a direct violation of their own rules.

The logic is simple. Because NCBs will now be accountable for the quality of the assets they bring into the eurosystem, they will also be constrained on the number of assets they can create. Instead of a positive feedback loop, a vicious circle comes about very quickly.
From now on, as with a currency board, NCBs which lack enough high quality assets in their jurisdictions — because euro flows into their jurisdictions are not naturally forthcoming, meaning there’s not enough euros to redistribute to create assets without outright money-printing — will not be able to get the liquidity they need from the system. Instead, they end up facing the same sort of FX-exposure — in this case the Frankfurt controlled euro (because they can’t control the printing of their own euro liabilities) — that commercial banks on a currency board are exposed to because they too can’t control the inflow or supply of FX into their own systems.
This is why, in Buiter’s mind, Draghi’s profit-and-loss sharing ruling transforms the 19 NCBs of the euro-system into nothing more than dependent commercial entities of the master central bank: the ECB. In the long run, it’s a structure that puts more pressure on NCBs that don’t have naturally occurring euro inflows into their jurisdiction, and threatens NCB insolvency.
Hence why, according to Buiter, in the long run it’s a policy decision that at best delays the prospect of profit and loss sharing, rather than prevents it. At the end of the day, if an NCB was to go bust, the only way to save the system would be by post-event profit and loss sharing:

So, yes, the choice will be if central banks’ exposure to an insolvent sovereign, were to rise to the point that certain central banks faced insolvency , in a situation where the sovereign is unlikely to be able to recapitalise it because the sovereign going bank is the reason why the central bank is in trouble, at that point you have a choice. Either we settle ex-post and say we didn’t mean it, here comes the ex-post risk-sharing or the country with the insolvent central bank tries another monetary regime.
So that’s the very stark choice. And my guess is that in the great european tradition of saying one thing and doing something else if it becomes too costly to stick to what you first proposed, there would be ex-post risk sharing.

All of which, he noted, only adds needless uncertainty, lack of confidence, and market volatility into the system, including the possibility of bank runs, none of which would be there if the national central banks were just branches of the ECB.
In fact, according to Buiter, NCBs should probably have been transformed into ECB branches long ago. Furthermore, if an NCB was to go bust, chances are the market would create the conditions to allow such branches to manifest either way.
As Buiter explained:

…the Greek banks can’t go to the Bundesbank, but they could go, in principle, to Frankfurt — to headquarters –and if Frankfurt wanted to it could even open a small side office in Athens or wherever and bypass the national central bank. This wouldn’t be polite, but there’s nothing in the treaties that precludes the ECB itself from doing anything that the national central banks do. So the possibility of getting rid of this historically very understandable but completely ridiculous arrangement of 19 independent legal entities as national central banks and replacing it with one supranational entity the ECB is there.

In such a scenario, Buiter says cash in a bankrupted NCB’s jurisdiction would remain legal tender as would cash balances and deposits of the commercial banks at the national central bank in question.

They are eurosystem liabilities. You’re responsible under these strange own risk rules for losses on the assets, but you can’t just waive your liabilities goodbye.