European Central Bank: Still off-centre
Why are journalists and politicians still sniping at the European Central Bank? Except for the euro’s gentle decline, it hasn’t put a foot wrong. Apart, that is, from bad public relations, grand plans to eclipse the national central banks, and a still crazy auction system. What could be better than that? David Shirreff reports
The European Central Bank is part of the Frankfurt landscape. The once-drab office tower which housed the Bank für Gemeinwirtschaft glistens like a new e5 coin. Yet it is dwarfed by the futuristic towers of Hessische Landesbank, Commerzbank and DG Bank and the more dated monsters, those coupling giants Deutsche and Dresdner.
The giants nevertheless are watching the dwarf's every move. Because the ECB presides over a network of 11 central banks, including the once-mighty Bundesbank just three kilometres away, which manage the world's second most important currency, the euro.
The euro is only 15 months old so it has no proper history: the ECB makes it up, and decides on the basis of this Fiction whether the key short-term interest rate should go up, or down, or stay the same. Hundreds of banks, economists, academics and investors likewise have their own version of eurozone economics and try to guess what the philosophers of the ECB council will decide at their next meeting.
This is a frustrating game for all participants. The ECB reserves the right to be unpredictable, yet not so unpredictable as to amplify market volatility. The market players want more information, and accuse the ECB of being as transparent as a black box. The game is likely to go on for a few years until the ECB, its behaviour, and the signals it gives out, have established a track record and shown some consistency.
The hub of a federation
The ECB is not a monolith, in fact it is the hub of the ESCB (European System of Central Banks). The Bundesbank, on which it is partly modelled, has a job achieving consensus among its nine regional central banks (Landeszentralbanken) all of the same nationality. So it would hardly be surprising if 11 different national central banks (NCBs) had difficulty reaching agreement on a short-term interest rate for the eurozone.
Even euro-sceptics note, however, that ECB council members have been known to vote against their short-term national interest in favour of an interest rate to serve the eurozone as a whole. Perhaps they were selected for their altruistic tendencies.
There is still a whiff of revolutionary zeal hanging around the corridors of the eurotower.
That was understandable in the unnerving run-up to the euro's birthday on January 4 1999, and perhaps until the world had got over the Y2K hiatus. But now the ECB is established and has got over these humps, perhaps it should relax the ideology a little.
Tommaso Padoa-Schioppa, veteran of the respected Banca d'Italia, and a member of the ECB executive board, says the market appears to misunderstand the economic fundamentals of the euro. The euro, since its inception, has lost 17% of its value against the US dollar.
That simply doesn't reflect the fact that the euro area economy is in a better situation than it has been for the last decade "even in the Weld of employment", says Padoa-Schioppa.
It's an improvement that the market fails to fully incorporate in its judgement, he says, adding: "The characteristic of markets is not to be always right, but to correct their mistakes."
He notes that the market is tougher on ECB decisions and utterances than on those of other major central banks. Isn't that because these are tried and tested central banks? They do have a track record, he agrees.
Padoa-Schioppa dismisses the suggestion both that the market is punishing the euro with a risk premium and that this might be because of the hybrid nature of the ECB system, whose dynamics aren't yet properly understood.
Rather he suggests the euro is being speculated against by "yuppies Finding reasons to push down the euro".
How would the ECB respond in a liquidity crisis? "Fortunately we haven't been tested on that," says Padoa-Schioppa. But he doesn't believe any more reassurance can be given to the market on this score. "As far as things can be told in advance, we did."
Padoa-Schioppa published a paper on this subject in February 1999, pointing out the "double separation" of the ECB, functionally and geographically, from the epicentre of a banking crisis anywhere in euroland. That remoteness can be overcome by close cooperation between supervisors and national central banks (NCBs), and between the NCBs and the ECB. In a crisis in a single eurozone country the NCB is the First line of defence. Such a crisis can be dealt with in three ways, depending on its nature: with private money, with central bank money, or with taxpayers' money. If insolvency of a Financial institution is the issue, then private money or taxpayers' money will have to shoulder the losses. But if it is a liquidity problem of a systemic dimension there exists contingency capacity for emergency liquidity assistance (ELA) at the national central bank level. How much and on what terms is kept deliberately vague: Padoa-Schioppa, like many central bankers, believes in the value of "constructive ambiguity" to avoid moral hazard and to encourage the private sector to seek its own solution.
However, euro-sceptics and other doom-mongers are worried that the ESCB, relying on a decision from 11 separate NCBs and perhaps their respective national treasuries, wouldn't be able to respond quickly enough to a bush Fire. "We already faced a situation where we had to take a decision in two hours," says Padoa-Schioppa, "although this was in the field of payment systems, and foreign exchange policy." An emergency is not a road "on which the car has yet been driven".
Would it not be valuable to test the vehicle on some rough terrain - by simulating crises for instance? "We do test these things internally, not externally," says Padoa-Schioppa. "We do exercises, but we don't call in the press." Testing them in public would sacrifice "constructive ambiguity". Also, he adds, "the next emergency will never be like the previous one, so you will never build a portfolio of crises that will anticipate the next".
But there is a limit to the range of probabilities that the ECB is prepared to test. Considering the consequences of a country leaving the euro is "not part of the agenda".
"Because it's not foreseen in the Maastricht Treaty. I won't discuss this topic: I'm a central banker not a politician," says Padoa-Schioppa.
However, the EU's recent spat with Austria, over its inclusion of the right-wing Freedom Party in its ruling coalition, raised the spectre of an EU country being put beyond the pale. If Austria's voting rights were suspended, under article seven of the EU Treaty it would become little more than a colony of the EU and might decide to withdraw from the union and the euro. This is a low-probability but high-cost event that arguably should be thought through even by central bankers.
The suspension clause was written into the EU Treaty (article seven) by the Treaty of Amsterdam. Under this clause, some of a member state's rights (eg, its voting rights in the council) may be suspended if it breaches the principles on which the EU is founded (liberty, democracy, respect for human rights and fundamental freedoms, and the rule of law). Its obligations, however, would still be binding.
France places a midnight call
Padoa-Schioppa is reluctant to describe how the ESCB and the 11 national central banks manage their reserves: "We don't give details of the management and currency mix. The governing council decides on the internal guidelines for this."
The national central banks manage the ECB's reserves which total around e40 billion. Each NCB also manages its own reserves as a prudent fund manager but not to influence the ECB's exchange rate policy. These reserves "are an asset of the Eurosystem", says Padoa-Schioppa, so there is no inherent conflict of interest between the management of ECB's reserves and the way the reserves of individual NCBs are managed. These extra assets could be called on if the ECB needed them: "We have put a procedure in place," says an ECB banker.
Two rows are brewing, however, both involving France. France wants to sell some of its gold to fund state pension obligations, but last year it signed a 15-nation agreement to limit central bank gold sales. Can it side-step ESCB policy and sell its gold through the French treasury rather than the Banque de France. The Maastricht Treaty isn't clear on this point.
France also took the initiative on March 8 when the Bank of Japan intervened to buy dollars but omitted to buy euros as it should according to a G3 agreement. It was the French who called Japan in the middle of the night to put them right, not the ECB, say informed sources. The ECB was reportedly furious.
ECB-sceptics don't like this potential for fragmentation. In fact they see fragmentation elsewhere too - in banking supervision (or more strictly banking sector monitoring), and research.
The European Shadow Financial Regulatory Committee (ESFRC) in October 1998 called for a European observatory for systemic risk. It noted that there is no central monitoring of bank liquidity - this being left to national central banks. "It was discussed in the ECB but killed by the politicians," says ESFRC chairman Harald Benink. The ECB has a committee on banking supervision headed by Bundesbank director Edgar Meister, but this has no monitoring function.
Research is becoming a battle for attention between the ECB at the centre and the research departments of the national central banks.
Some see this as costly duplication, others regard it as healthy competition.
"The ECB was meant to be very light, now it's developing as a huge institution," complains a French economist. It has 160 staff working in research and economics and vacancies for 50 more. "That is huge [duplication] if you think of the hundreds and hundreds of central bankers in Europe."
Ignazio Angeloni, deputy director general for research at the ECB, says that this "does not need to entail an increase of staff in the Eurosystem", since a number of recruits have come from the NCBs. It's vital that the ECB should develop its own research with a "euro-system type mentality ... we have a natural euro-area perception, while staff at the NCBs often have responsibility in analysing the national developments as well". However, the Bundesbank for one would dispute this.
The ECB has two research divisions, one devoted to econometric modelling, the other to general economic research. The econometric people combine modelling work with forecasting jointly with the ECB's directorate-general of economics. "The national central banks are also heavily involved in forecasts," says Vitor Gaspar, the ECB's director general of research.
The general economic research division (GERD) does more theoretical work on such things as monetary policy issues, including strategies, rules and transmission mechanisms. It also looks more broadly at the structure of Financial markets, the international use of the euro, the structure of banking in the euro area, and banking fragility.
Is there no overlap with what the national central banks are doing? "The NCBs have a lot of resources and experience," says Angeloni. "Every day we exchange ideas and information - it's a large part of our activity."
Gaspar insists: "The centre needs a strong, autonomous, analytical component." Some outsiders see this as empire-building by executive board member Otmar Issing, former chief economist at the Bundesbank. "He has control of the ECB's monthly bulletin, which gives him great power," says a London-based economist, "just as [former president] Helmut Schlesinger did at the Bundesbank."
Central banks always have to be cautious about the impact that releasing their research might have on Financial markets. But some economists believe the ECB is almost paranoid in this respect. "Why have they done no work on structural unemployment in the euro area?" one asks. We are researching it, says Gaspar, "we can't publish research until it is complete".
Paranoia may be too strong a word, but the ECB appears frustratingly cautious about giving messages to the market, with the result that tiny nuances - in remarks by individual council members, for example - can have a devastating effect. A remark by executive board member Christian Noyer, in February, implying that the ECB's monthly report should not be taken too seriously, meant that an almost certain rate hike had to be ducked on March 2, according to ECB-watchers.
The Bundesbank ran monetary policy on the basis of monetary targeting, whereas the ECB makes much of its "two-pillar" approach, targeting being one pillar and the second pillar a view on the inflationary outlook. The second pillar gives it a great degree of Flexibility, turning monetary policy into more of an art than a science.
That is Fine, but academic economists Find it impossible to apply the tools of their trade to predict decisions by the ECB. That may be just as well, since the raw material - the data aggregated by Eurostat and the ECB itself - have hardly had time to shake down into a picture of euroland.
Cautious monetary policy
The ECB has been extremely cautious about the conduct of monetary policy. It has a great array of instruments available to it - eclectically drawn from the money-markets of pre-euroland - to Fine-tune the money supply, but so far it has used only two: banks' minimum reserves, and its weekly Fixed-rate auction. There has been one exception. On January 4 this year, it suddenly called for a tender from a handful of banks to mop up liquidity after the non-event of Y2K. For a moment the money-market rate had fallen 40 basis points below the 3% repo rate. Curiously the ECB had cancelled the weekly auction which would have mopped up this liquidity anyway.
Instead of an auction open to all euroland banks it preferred to invite its trusted players to a party that had to be decided in one hour.
Apart from that, the weekly Fixed-rate auctions have been its only instrument. And in some ways they have become a bit of a farce.
Banks have to bid for around 30 times the allocation they wish to receive, all because the ECB was afraid the German banks would have an advantage. German banks tend to have tons of collateral: other European banks less so.
So the ECB freed banks from the constraint of bidding only up to the level of the collateral they intended to put up. Since then, the bids have soared into the trillions of euros, in the sure knowledge that only a fraction will be allocated. Even if a bank is allocated more than it bargained for, it has around 24 hours, from late Tuesday morning into Wednesday, to Find the extra collateral.
Says a central banker: "The ECB tries to counteract the overbidding problem by providing a lot of liquidity to ensure the tender rate is close to the overnight rate.
It's a good idea, but it doesn't work very well."
The solution would be to run a variable-rate rather than a Fixed-rate auction. But for various reasons the ECB hasn't yet dared to do this. Instead of bidding for an amount of cash at the pre-Fixed repo rate, banks would win the allotments they wanted according to the rate they indicate they are prepared to pay.
That would be letting the market more directly set the interest-rate ceiling. Although this would end the craziness of inflated bidding and be more like the US system, the ECB fears it would add to the volatility of euro interest rates. "The ECB seems to be afraid of markets setting a rate," says a big money-market player in Frankfurt. "The big risk is that for 80% of the banks in the eurozone it would be their First experience of this system. The ECB may have to allocate at bids it normally wouldn't like to see. Some banks are hungry for liquidity."
The ECB wants to maintain a level playing field in the money market. Yet the big cross-border Flows are inevitably in the hands of a few players - "the top Five banks in each country", says the Frankfurt banker. The big banks are more natural holders of eligible collateral, and the core euroland countries (Benelux, France, Germany) have better-organized links for putting up collateral. In theory a bank in any euroland country can post collateral of any nationality at the relevant national central bank by using the CCBM (cross-border central banking model), and the volumes are growing (see chart).
But the type of asset that is eligible varies from country to country. For example only Austria, France, Germany and Spain accept bank credits as collateral; only the Netherlands accepts equities - although these classes of assets are regarded as "non-marketable" tier-two collateral with a heavy haircut. Only certain countries, notably Germany, have pools of Pfandbriefe or the equivalent - they are tier-one collateral eligible for discount at the NCB and with a haircut close to that of a government bond. There is no discrimination according to the perceived credit quality of any euroland government bond. They all get the same discount. That has not led, as some sceptics feared, to bad bonds driving out good. Not only the higher-yield, lower-priced, Italian government bonds are used as collateral. "Although there is a small opportunity cost in using, say, German Bunds, banks tend to reach for what they have available," says a central banker.
But there is political discrimination against non-euroland collateral. "There are two categories of country," says a central banker, "if you want to use the euro it's better to be in the euro area. There's no conscious discrimination. I think it is still easier to use the euro in London than the US dollar."
Euromarket banks have lived for a generation with the inconveniences of the Euro-dollar, and will probably learn to live with the Euro-euro. Collateral links in the CCBM are increasing all the time: in mid-March there were 53.
There is no doubt that the ESCB will learn to run more smoothly and the ECB will get better at implementing monetary policy. The contacts with the market are likely to become more centralized. One reason why the ECB has never intervened in the foreign exchange market is that it would be difficult to coordinate, yet giving an intervention order to just one or two NCBs would smack of discrimination.
Is the ECB allowed to intervene?
Moreover, the ECB is not confident that it could have much effect on the euro exchange rate unless there were a concerted effort by the G3 - the US, euroland and Japan.
It has even been suggested that the ECB cannot intervene without being given a regime (range) by the Ecofin council (the EU council of economy and Finance ministers). An ECB banker agrees: "Yes, but that includes the decision not to have a regime, which is the present case." Wouldn't that mean, that if the ECB did intervene it could be sued by a wrong-footed investor, say a macro hedge fund that had lost a lot of money, for acting ultra vires? "That was discussed in 1999: we can intervene, it's crystal clear."
But the mechanics of intervention would be a logistical nightmare. "You would instruct the national central banks to reach a level or a range, and that will be difficult with 11 of them. I would prefer to have a centralized system," admits the ECB banker. "Decentralization is costly." It's also a political nightmare. One of the problems is national central bankers, remote from the centre, shooting their mouths off about interest or exchange rates. "Why did the FT quote Kühbacher on interest rates the other day?" asks a frustrated euro-banker. "Kühbacher is nothing." Klaus-Dieter Kühbacher is president of the Landeszentralbank of Berlin and Brandenburg and thus a member of the Bundesbank's central council. "But the Zentralbankrat doesn't mandate [Bundesbank president] Ernst Welteke how to vote in the ECB council," says a London-based economist.
The future for the ECB suggests that there will be more centralization, especially as more euro members from an enlarged EU would dilute the European System of Central Banks. "It would help [already] if we had a somewhat stronger centre, perhaps eight executive -directors and nine national central bank members [today the ratio is six to 11]," says Deutsche Bank ECB-watcher Ulrich Beckmann.
Bernard Connolly, international economist at AIG and a renowned eurosceptic, believes that a much stronger ECB and a central economic government for euroland are the only way the zone will hang together in the long run. "France will try to change the EU voting system to qualified majority voting [neutralizing a single country's power to veto EU legislation]. It will want to create a permanent secretariat for economic affairs, which will become the framework for an economic government." He believes such a government would be intergovernmental, not federal. It would be technically feasible "but I have grave doubts about whether such a Europe could hang together politically", he says.
By that time, Connolly predicts, euroland will have had to break the no bail-out principle (embedded in the Maastricht Treaty) to rescue a country - possibly Ireland - from an asymmetric shock to its economy. "The smaller countries, including Spain, are heading for the buffers at high speed," he says.
This is because they have no instruments, apart from Fiscal policy or cross-border labour mobility, to combat national inflationary pressures.
An ECB banker is not so alarmist, but he does make one prediction that the ESCB will become more centralized over "the next 10 to 15 years".