August 30, 2012 / 3:33 PM / 5 years ago

Analysis: More ECB bond buys may need new cash-mopping tools

5 Min Read

LONDON (Reuters) - A new round of government bond purchases may eventually force the European Central Bank to use some of its yet-to-be-tested tools to soak up the additional cash in the euro zone banking system.

This may include extending the time its is willing to hold commercial banks' money, or even issuing bills.

At its meeting on September 6, the ECB is expected to unveil a plan to bring down Spanish and Italian borrowing costs and ease the euro zone's debt pains by buying more debt under some conditions.

Because little detail has been made public, market participants are speculating about how this will work, including so-called "sterilisation", which central banks use to ensure that there is no extra money in the system as a result of such a policy.

This is usually done by offering commercial banks good interest rates to deposit money with the bank for a week. But it may be that the amounts involved this time are too great for that.

Analysts generally expect the ECB to sterilize any new bond buying because doing so is key to keeping the ECB's inflation targeting mandate credible and to set it apart from other major central banks such as the Federal Reserve and Bank of England which have simply printed money to help their economies recover and not drained it.

That would be outright quantitative easing, which has strong opposition in Germany, which has philosophical concerns about anything that would smack of ECB funding governments.

To have a significant and lasting impact on Spanish and Italian bond yields, however, the ECB's next forays into bond markets may need to be of the order of hundreds of billions. Add that to the 209 billion euros worth of previous bond purchases the ECB is already draining every week from the system and some analysts say there could be failed auctions of one-week deposits.

"Clearly if you talk about high volumes, there is an issue with sterilisation," said Carsten Brzeski, a senior economist at ING. "They will probably have to use other tools than they currently do."

"The other option would be not to sterilize, but then they would clearly have a problem with the Bundesbank and the German public because the risk for future inflation would clearly increase."

Broken Pipes

In theory, the excess liquidity within the euro zone banking system - at about 760 billion euros according to Reuters data - should ensure that the one-week deposit auctions the ECB currently uses would be sufficient to absorb the cash.

But stressed euro zone money markets make the process more complicated than it would seem at a first glance.

For instance, Spanish and Italian banks - which are loaded with their domestic sovereign debt and are likely to sell some of it to the ECB - are not necessarily the ones that would bid at the ECB's cash draining operations.

Most of them are dependent on ECB liquidity and they may not be willing to give it back. The ECB would most likely have to rely on the same bidders that it attracts at its current auctions.

In the past 10 auctions, banks bid an average of roughly 415 billion euros. It is unclear if those banks would be willing to park more cash into one-week deposits that offer returns of 1 basis point should the ECB need to.

"Liquidity is no longer one big pool with lots of little pipes going in and out, but a lot of different containers that aren't linked up," said Luca Jellinek, head of European fixed income at Credit Agricole.

One option to maintain enough demand is to lure banks with higher rates, but that could be regarded as a tool to tighten monetary policy, the opposite of what the ECB has been trying to achieve since Mario Draghi took the helm late last year.

It is more likely that the ECB would extend the maturity of their draining operations, potentially by issuing bills, something the bank has never done before.

"If they needed to, they could potentially issue their own paper ... which even with a modest or even a flat yield should garner very significant demand given that the front end of the core curves are trading in negative territory," Rabobank strategist Richard McGuire said.

The ECB's rules allow the bank to hold tenders to mop out cash as frequently as it wants, for as long as it wants. If needed, the ECB can offer deposits on a bilateral basis and it can also use foreign exchange swaps to absorb liquidity.

Additional reporting by Marc Jones. Editing by Jeremy Gaunt.

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