How did the Eurosystem facilitate tiering?

Slides: Tiering adjustment_FINAL

pdf: How was tiering facilitated_FINAL

On 30th October, the European Central Bank’s (ECB) new tiering system came into operation, resulting in the reshuffling of liquidity across the Eurosystem. As noted previously, and reported variously, this caused a record one month decline in Italy’s TARGET2 debit, falling EUR48bn to reach EUR420bn—the lowest debit for 2 years. At that time this blog speculated the introduction of tiering created an arbitrage opportunity, allowing Italian banks to draw in liquidity to deposit at 0%. As liquidity was returned to the periphery, TARGET2 balances adjusted.

This hasty “interbank” interpretation of adjustment was reasonably challenged—on twitter and elsewhere. Indeed, at the time it was noted how “other sources of funding” might provide an alternative explanation. And, over the past few weeks, further data allow a more nuanced interpretation of this adjustment. Moreover, a recent piece by the ECB confirms a key role played by collateralized lending in this process. Here we therefore contemplate again this adjustment.

Various data shed light on evolving Eurosystem balances. Daily data on aggregate liquidity; weekly data on the Eurosystem and Bundesbank balance sheets; 6-weekly snapshots of the disaggregated Eurosystem National Central Bank (NCB) balance sheets reported by the ECB, amongst others. We begin recalling the pre-tiering snapshot on the distribution of Eurosystem liquidity.

Snapshot: Early-October

Figure 1 shows ECB data on the distribution of deposits—current account and deposit facility, or “total liquidity”—as of 4th Oct, 3½ weeks before tiering.


Total liquidity was predominantly held on current account with respective NCBs—largely in Germany (EUR617bn) and France (EUR467bn) where 58% of the aggregate  1,864bn held by respective monetary financial intermediaries (MFI) was kept. Against this, not shown, withdrawn from availability as reserves in the aggregate was EUR269bn held by governments, EUR138bn by other non-MFI intermediaries, and EUR230bn by non-residents. Beyond the redistribution of reserves, these provided alternative sources of liquidity for MFIs to fulfill tiering.

Total deposits relative to required-plus-tiered reserves (Figure 1, right side) reveals a number of countries’ banks were, as of 4th Oct, short of the liquidity needed to exploit tiering. A ratio of 1 implies enough reserves already available within the domestic banking system—not necessarily distributed suitably within the country, of course. While the aggregate ratio was 1.85, country level aggregates from Ireland down point to fewer reserves—and banks in Portugal, Slovakia, Italy, and Greece, at less than 1, were short of the amount needed to meet local tiering possibilities without drawing upon reserves from abroad or elsewhere.

Daily data: Aggregate liquidity

Figure 2 shows system-wide excess liquidity from 4th Oct—defined as total liquidity minus required reserves. Driven by “autonomous factors and monetary policy portfolio” (AF) flows, excess liquidity fell roughly EUR45bn, from EUR1,730bn to EUR1,685bn, before increasing sharply during the days immediately before tiering came into effect. Thereafter, excess liquidity further increased to EUR1,815bn on 8th November—the highest stock since mid-June.


Meanwhile, within excess liquidity can be witnessed a last-minute switch from the deposit facility to current accounts. Indeed, the deposit facility fell about EUR240bn on 30th Oct, when current accounts increased roughly the same amount. Over the following week, liquidity held at banks’ current accounts with the ECB increased a further EUR65bn before rolling off along with AF.

Liquidity held in current accounts prior to 30th Oct was already more than enough to satisfy the system’s aggregate required-plus-tiered reserves. The last-minute switch from deposit facility is perhaps another expression of asymmetric intra- and inter-country liquidity distribution.

The contributions of AF and the deposit facility to the cumulative change in current accounts since Oct 4th is shown in Figure 3. AF withdrew liquidity before liquidity was added around the time tiering came into effect.


Weekly data: Adjustment to tiering

Further information is provided by Bundesbank and Eurosystem aggregate balance sheets—weekly snapshots available every Tuesday for the preceding Friday.

Figure 4 shows total liquidity in Germany and the rest of euroarea (ROEA.) The axes are different, but the scale on each is EUR140bn. Liquidity in Germany began on 4th Oct around EUR620bn, trending down to about EUR580bn on 22nd November; through 25th Oct falling EUR24bn. Over the period through 8th Nov, liquidity in Germany was largely unchanged. Initially total liquidity in ROEA shrank before increasing sharply—during the three weeks from 18th Oct and 8th Nov by EUR23bn, EUR50bn, and EUR28bn respectively, a total of EUR101bn.


Over the crucial period leading up to tiering on 30th Oct, between 4th Oct and 1st Nov, liquidity in Germany fell EUR19bn while ROEA saw liquidity increase EUR56bn.


Figure 5 decomposes the cumulative change in liquidity over this period into the main balance sheet items. After falling initially, total liquidity increased sharply into the first two weeks of Nov in the aggregate (left panel). The two main drivers were government and other deposits (about 2/3rds) and non-resident euro deposits (about 1/3rd).

However, the drivers in Germany (middle panel) versus ROEA (right panel) were different. As noted above, the cumulative change in total liquidity in Germany through 8thNov was roughly zero. However, there were contributions to liquidity of EUR23bn by government and other deposits, and from non-euroarea residents of EUR21bn. Against this, Germany’s TARGET2 credit contracted EUR40bn through 8thNov (and EUR56bn through 1stNov.)

The counterpart to these flows, of course, was largely a decrease in TARGET2 debit of ROEA—the mirror of Germany’s credit. Onto this was a contribution to liquidity from government deposits and non-euroarea resident deposits.

As noted previously, non-euroarea euro deposits represent reserve manager euro claims yet to be allocated to securities. In a sense, they represent asset purchase program (APP) purchases by the Eurosystem from non-resident central banks that have yet to be re-deployed. Thus, it represents a liquidity buffer. The interest on these deposits at the Bundesbank are the deposit rate minus 15bps, so since September -65bps. And if the front end of the safe asset euro yield curve provides a negative rate below this, absent a change in attitude to risk, reserve managers should just keep these euros as deposits with the Eurosystem. But once the front end of the yield curve touches -65bps, there is an incentive for these deposits to be rundown and rotated back into securities once more. This provides a cap on the front end of the bund yield curve.

Figure 6 shows the daily yield on AAA securities in Germany reported by the Bundesbank. Yields were pushed ever lower across the curve throughout the course of 2019. A snapback in yields accompanied the September ECB meeting—arguably markets were hoping for a more aggressive rate cut by Draghi. By the first week of October (right panel) 1-5Y yields were consistently below -65bps. But during the week preceding 25th Oct, yields moved higher—coincident with the decline in Germany’s TARGET2 credit. This would be consistent with bund sales by non-Core banks preparing for tiering, dragging yields higher until non-resident reserve managers in turn were dragged back in as the yield touched -65bps.


Indeed, the inflow from non-resident deposits of  23bn during October helped bring non-resident deposits with the Bundesbank below those held across the rest of the Eurosystem for the first time since 2016. Figure 7.


Monthly data: Which countries drew on external resources?

It might be expected that countries with TARGET2 credits prior to tiering, like Germany, might witness capital outflows while debit countries inflows in the run up to tiering. Figure 8, using the 4th Oct and 1st Nov balance sheet data from ECB, shows how this simplistic view is misleading. The chart shows the initial TARGET2 position and the change over this period for 9 major economies. If all creditors to the system saw capital outflows, and all debtors inflows, the chart would show balances moving in a clock-wise direction. Indeed, while Germany (-EUR57bn) and Italy (+EUR69bn) are consistent with this view. However, some creditors—such as Finland Luxembourg—saw inflows and larger TARGET2 debits post-tiering. Meanwhile, Spain saw outflows despite beginning with an initial debit balance. Belgium and France started near zero initial TARGET2 position and each saw outflows.


Figure 9, finally, decomposes the contributions to the change in current accounts for these same countries over the same period. In very case the deposit facility was drawn down (a positive contribution) to top up current accounts. As noted above, the TARGET2 system saw some countries accumulate liquidity flowing from Belgium, France, Germany, and Netherlands. Meanwhile, German liquidity benefitted from inflows by non-resident reserve managers.



Argentina: BCRA accounting and government debt

Slides: BCRA_October 2019

pdf: Argentina_BCRA accounting

Buried deep within the monthly balance sheet of the Banco Central de la República Argentina (BCRA) is an arcane accounting entry of crucial import. The entry in question, reported as “Cents Varias,” is more often labelled in IMF documents as Other Items Net (OIN.)

Now, OIN is indeed a misunderstood accounting entry—thus greatly abused. People sometimes think of it as similar to “errors and omissions” reported in the BOP—a measure of our ignorance. This makes it tempting to use OIN as a residual when projecting or interpreting the monetary accounts. But OIN is completely different. Rather, it scoops up balance sheet items that, though not typically pivotal, can still of value in interpreting macro-financial developments. As for Argentina.

Consider the latest BCRA September balance sheet snapshot. Figure 1 shows OIN in local currency on the left and, on the right, BCRA’s net open position (NOP) alongside net foreign assets (NFA) measured in USD. NOP here being the value of foreign currency assets minus liabilities held against nonresident and residents (NFA being that against nonresidents alone.)

To be clear, net equity is a liability on the BCRA balance sheet. But it enters OIN with the opposite sign as it is shifted for analytical purposes to the asset side of the balance sheet. As such, ARS depreciation that would typically cause revaluation of NOP, recording a paper increase in net equity, in fact pushes OIN ever lower—that is more negative. And as previously argued on this blog, these paper gains have been historically converted into local currency as profit transfers, further undermining the currency.


But eyeballing Figure 1, what happened in August? Despite the sharp ARS depreciation, expected to drive net equity higher and OIN negative, instead OIN leaped higher—moving from about -ARS650bn in July to +ARS300bn in September. (Figure 1, left side.) Why? Good question. The right side of Figure 1 provides a clue in presenting USD value of NOP and NFA. While NFA fell sharply on intervention to hold up the currency (from USD47bn to USD29bn) overall NOP fell even further (from USD62bn to USD30bn).

Figure 2 breaks out the NOP further into NFA, net FX claims on the government, and net FX claims on the financial sector. The former is, roughly, familiar reserve assets minus China swap lines. The latter reflects some FX deposits of the financial sector. Meanwhile, net FX claims on the government are the legacy of FX credit provided to the government over years of fiscal dominance. And it is these net FX claims that have fallen most sharply of late, concurrent with ARS depreciation. Indeed, net FX claims fell from USD30bn to only USD10bn.


Figure 3 further decomposes net FX claims on the government (left side) and net foreignassets (right.) The left chart in particular shows how FX claims of BCRA—that is, government debt owed to the central bank, denominated in foreign currency—was sharply reduced in August and September. To be precise, these claims fell from USD42bn to USD14bn. Liabilities to the government also fell, so the change in the net position was less pronounced. But clearly, government debt to BCRA fell precipitously in August and September.


So, has the central bank written off government debt? Sadly, no.

Upon careful inspection, it turns out this is not the only time this has happened. Barely visible in Figure 1 is the fact that OIN fell sharply in June 2018 as ARS depreciated, but also increased sharply in July—to be precise, falling from about -ARS620bn in May 2018, to -ARS870bn in June, before rebounding to -ARS420bn. So the imprint of ARS depreciation in the June depreciation was quickly offset. And the 2018 BCRA Financial Statement sheds some light on this episode (see pages 16-17), where it explains how, whereas previously claims on the government were “held to maturity” they decided in late-2017 these would be somehow marked to market.

To be quite honest, the explanation is mostly gibberish to me. But it seems that BCRA decided to apply a more realistic valuation of their holdings of claims on the government. Thus, whereas previously the upward valuation adjustments of claims on government during periods of exchange rate weakness created profit transfers, from last year BCRA instead undertook to mark down cumulated claims on the government at such times of disruption.

Further confirmation of this is available in the BCRA weekly balance sheet reporting. Figure 4. Now, the weekly balance sheet does not have quite the same sectoral and currency breakdown. But it includes a curious memo item from 2019. That is, the weekly balance sheet reports “Net equity” but also that valued “with nontransferable bills at ‘technical value.’” While the former captures the value of BCRA claims on the government “marked to market,” the latter reflects, I guess, the held to maturity value in local currency. And this indeed confirms that BCRA took large losses on their claims on the government coincident with the sharp August depreciation. As such, whereas net equity was recorded at ARS580bn at end-July, it reached -ARS130bn by end-August (recall, this enters with the opposite sign in OIN as it jumps across the balance sheet). In contrast, the “technical value” of these FX claims increased with the exchange rate depreciation, confirming BCRA has indeed written down the value of claims on the government on their balance sheet.


We ought to clear up a few points here—and offer some parenthetical remarks. First, has BCRA “written off” government debt, meaning debt is now actually lower? No. The debt remains unchanged in debt stock numbers. This is simply recognition by BCRA that the government’s liabilities are not worth the paper they are written on. Consider how they have written down USD67 billion in FX claims on the government to USD14bn. That’s an 80% haircut. And bondholders are apparently arguing for a re-profiling of debt. Seriously.

Still, in terms of motives, this revaluation perhaps reflects past frustration that paper gains following ARS depreciations were monetized. Thus, maybe BCRA got ahead of the government by marking down their assets and, by end-August, reporting negative equity. It’s difficult to argue in favor of monetizing negative net equity.

Two more observations. Somewhat visible in Figure 3 (right side) is the extension of swap lines by China during 2014. This was, meanwhile, coincident with increasing BCRA FX claims on the government (left). Thus, in a sense, BCRA appears to have been intermediating funds from the Chinese authorities to the previous government. This clearly helped the previous and more recent government delay adjustment—as did more recent IMF official support. Such lending doesn’t really help. There is a strong case for debt relief on such official support, in my view.

Finally, while the government had previously provided “ring-fenced” deposits at BCRA as part of the IMF program, intended to help shore up international reserves, these have fallen sharply in recent weeks. Figure 5. Following the election result and pressure on the currency, the government has used most of these.



Italy: Tiering up in October

Tiering up for Italy in October

THE ECB’s new two-tier system for excess liquidity began operation on October 30th. As a result, up to six times banks’ required reserves held in current accounts with National Central Banks (NCBs) of the Eurosystem will no longer be subject to the negative deposit rate (currently -50bps) but rather the new tiering rate of 0% interest. The surplus above this will be charged, however.

Of course, over the summer euroarea “core” banks had liquidity far in excess of this tiered ratio. Meanwhile banks in the periphery—Italy in particular—had less, mirroring TARGET2 imbalances. For example, German banks in August had perhaps 16 times required reserves in excess liquidity, Italian banks only slightly more than 3. Any rebalancing of excess liquidity to take advantage of the tiering system held out the prospect of somewhat unwinding previously accumulated TARGET2 imbalances—a happy side-effect, perhaps.

The publication on Friday of the end-October Bank of Italy balance sheet takes on additional significance, therefore. Can we detect the impact of the new tiering system?

Consider Figure 1. The Bank of Italy’s TARGET2 debit experienced the largest one month decline on record, falling  48 billion to reach  420 billion—the lowest level since October 2017. This is particularly interesting because there was already a sharp inflow in June following Draghi’s Sintra speech as markets anticipated the re-introduction of asset purchases—as there was in early 2015 in advance of Asset Purchase Program (APP) initiation. However, while this summer’s inflow drove Italian yields lower as a new and substantial buyer was in prospect, the October TARGET2 debit decline was after the announcement of renewed APP and not coincident with lower BTP yields. This suggests inflows not related to bond buying, therefore.


An additional clue as to the drivers of this sharp fall in the TARGET2 debit is provided by considering the counterpart balance sheet entry to these inflows. Indeed, since only bank NCB current accounts count toward tiered reserves, they would be a candidate destination. And indeed, banks’ current accounts with Bank of Italy increased  37 billion to reach  138 billion over the month of October, the highest level on record. Meanwhile, the deposit facility fell to the lowest level since early-2017. Figure 2.


To be sure, we don’t know for certain required reserves are in Italy. But they can be estimated at about  18 billion (1% of non-financial sector deposits). As such, required reserves plus six times tiering (7* 18 billion) is equal to about  126 billion. Roughly, banks in Italy would need this amount to avail themselves fully of the full tiering rate. And banks indeed appear to have generated such inflows over the last month.

Presumably, Italian banks access interbank funding at a negative rate from core banks for deposit at 0%, gaining a pickup in the process. Meanwhile, those core banks that would pay 50bps on excess-of-tiering reserves to the Eurosystem can now payItalian banks less for the latter to deposit in Italy instead.

Figure 3 shows daily unsecured interbank lending rates for the euroarea since early May as published by the European Money Markets Institute. These are priced off the transactions of 18 contributing banks, of which only two are Italian. This is an indication of possible funding rates.


Let’s suppose Italian banks had an aggregate shortfall rounded to  50 billion approaching end-October—we knowthey were holding  72 billion in current accounts as of 4thOctober, with  7 billion in deposit facility, so were roughly  50 billion shy of  130 billion. We cannot know the exact rate or tenor that Italian banks might have accessed funding to top up their liquidity for tiering, let’s imagine they accessed at the 3 month Euribor rate of -40bps. For Core banks with plentiful excess liquidity, they would pay 50bps for holding this with Eurosystem NCBs, costing roughly  20 million per month, or perhaps  1 million per working day. If they instead fund Italian banks at -40bps, they can reduce their aggregate monthly cost on this  50 billion to only  17 million, or about  0.8 million per day. Against this, Italian banks will be able to make a profit of roughly  0.8 million per dayfor borrowing from Core banks and depositing with the Bank of Italy at 0%. So in this thought experiment Italian banks are, in the aggregate, being paid about  17 million per month by Core counterparts to fill their tiering ratio. These Core banks, in turn, save themselves about  0.2 million in negative interest payments to their NCB in the process.

It is perhaps of some interest to note the change in unsecured interbank lending rates reported since October 4th, the prior reading on current accounts held by Italian banks. And through 7thNovember, so over roughly one month, interbank lending from 1 week to 3 months increased by about 2½bps; that on 6- to 12-months by more than 5bps. Perhaps this increase, if slight, is the imprint of greater lending to Italian banks for this purpose.

Alternatively, other sources of funding, if available at negative yields, would provide for similar gains. Italian banks could have issued securities, for example.


As to the origin of these funds, the monthly changes in liquidity and TARGET2 balances in creditor countries can be substantial—and driven by other flows. But the Bundesbank end-October balance sheet alone is broadly consistent with these flows. For example, Other Assets of the Bundesbank (a proxy for TARGET2 credit) fell  42 billion during October, while deposits of euroarea credit institutions in Germany fell  21 billion. The difference between these two being due to a reduction in non-euroarea deposits with the Bundesbank (i.e., reserve managers), which fell  15 billion, and general government deposits, which fell  12 billion. These therefore injected liquidity that would have otherwise fallen further owing to outflows (presumably) to Italy.

In any case, a curious side-effect of the tiering system, intended to shield core banks from ever-more-negative deposit rate, might indeed be to increase inter-bank funding and leave a potentially indelible impression on TARGET2 imbalances. To wit: Italian excess liquidity in October appears to have jumped sharply to cover required reserves plus exactly the 6 times tiering ratio.

Perhaps this is welcome in a world where TARGET2 imbalances for some take on Satanic proportions. Still, this rebalancing is small and one off. Big picture, it changes little. Though it does demonstrate once more that you don’t get $100 dollar bills lying on the sidewalk.


Draghi’s last stand

THE LAST meaningful monetary policy meeting overseen by outgoing European Central Bank (ECB) President Mario Draghi was not without controversy. Indeed, Draghi seldom disappoints. And once more he delivered an aggressive package of measures designed to achieve the ECB’s price stability target—including a number of fascinating policy innovations. Yet somehow this package is more than simply another set of innovations. This set of measures instead represents Draghi’s last stand—an attempt by the outgoing President to secure his legacy by casting a spell over monetary policy into the distant future, creating new policy tools while tying the hands of successor Governing Council members and his successor.

What was announced?

First, a reduction in deposit rate by 10bps to -50bps—alongside tiering of interest applied to bank deposits with the Eurosystem. As a result of the new two-tier system, up to six times the value of deposits in excess of require reserves will be exempted from the negative deposit rate—while any remaining surplus above this will be charged 50bps. Crucially, the 0% “remuneration rate of the exempt tier and the multiplier can be changed over time,” meaning the quantum and interest rate on this tier are subject to review. Crucially, this was not mechanically tied to the Main Repurchase Operations (MRO) rate—currently also 0%. Rather, it is a distinct—therefore new—Tiered Reserves Rate (TRR). In effect, the ECB created a new interest rate on a variable tier of banking system reserves—and therefore a new policy tool.

Second, recalibration of the third series of Targeted Long Term Repurchase Operations (TLTRO3)—due to be initiated this month—such that the 10bps premium over the main repo rate has been eliminated, the maturity extended from 2- to 3-years, while the interest rate charged could now fall as low as -50bps if bank lending targets are met.

Third, the reintroduction of the Asset Purchase Program (APP) at EUR20 billion per month for an open-ended period—that is, until stringent conditions on inflation are met. In particular, APP will “end shortly before we start raising the key ECB interest rates.” As for these rates they are expected “to remain at their present or lower levels until we have seen the inflation outlook robustly converge to a level sufficiently close to, but below, 2% within our projection horizon, and such convergence has been consistently reflected in underlying inflation dynamics.” In other words, roughly speaking, APP will continue until core inflation reaches near 2% for a sustained period of time.

How can we assess this package of measures?

Let’s start by recalling the previous policy stance and liquidity constellation, before contemplating the impact of the lower deposit rate and the two-tier system. What follows is my understanding—I welcome corrections or clarifications.

Something of a caricature, until Thursday last, the Eurosystem operated roughly as follows. There were two key sources of liquidity—TLTRO2s and past APP purchases. TLTRO2s are negative yielding assets, in that banks would receive the deposit rate of minus 40bps on these if they met lending targets—and roughly 90% of banks reached their lending targets, so de facto these assets tax the system 36bps per year. Against this, excess liquidity across the system—created by both TLTROs and APP purchases—is charged the deposit rate, meaning above reserve requirements banks are essentially taxed to pay TLTROs and create income for the Eurosystem.

With the exception of the coupon on Public Sector Purchase Program (PSPP) holdings—which could soon generate negative income, if not already in some cases—the monetary income across the system is pooled. So whatever is made through the using TLTRO2s and excess liquidity is shared according to capital key.

The distribution of excess liquidity, TLTRO, and APP purchases is shown in Figure 1 below, using data on disaggregated National Central Bank (NCB) balance sheets as of early-August.

Screen Shot 2019-09-15 at 21.33.14

Given we can ignore PSPP coupons, which are returned to the local NCB, we can have a go at calculating the income and outgoings from the policy stance prior to Thursday, and how this will change.

An important caveat is necessary at this point. We cannot back out the sharing of coupons from the various other components of the APP—such as Covered Bond Purchase Program (CBPP), supranationals, etc., as well as outstanding coupons from prior programs such as the Securities Market Program (SMP) etc. So we ignore this flow, which could be important and will depend on the distribution of purchases, including by the ECB itself, on behalf of the Eurosystem. In addition, the precise country-level TLTRO interest cannot be known based on information available, so we assume the lending targets were met equally across countries at 91¼% (see March, 2019).

With this, we narrow in only on the monetary income from TLTROs and excess liquidity alone. In Figure 2 (left side), income due to the negative deposit rate by country or group of countries is shown. In the aggregate, on these monetary policy-related operations, the Eurosystem makes a profit of about EUR4.6 billion. Germany makes income of about EUR2 billion on behalf of the system, while Italy makes negative net income of about EUR0.4 billion. But German profit is only EUR1.2 billion, Italian is EUR0.8 billion.

While Germany, France and other Core countries make some income from what will become “tiered liquidity”—separated out here—Italy and Spain make all of their positive income from this classification of liabilities. Their excess liquidity is below the ceiling of six times required reserves.

Screen Shot 2019-09-15 at 21.33.22

However, due to the sharing of monetary income across the system, some of the income from excess liquidity in the core is de facto transferred from the Core to the Periphery. Recall, aggregate monetary income is shared by capital key.  The income due to the sharing of monetary income is shown as “profit sharing” in the chart; de facto transfers are identified as “profit sharing.”

Indeed, income generated through the implicit tax on the banking systems of France (EUR0.7 billion) and Germany (EUR0.8 billion) and other Core countries such as Luxembourg is in effect transferred to the banks of other Periphery members such as Spain (EUR0.8 billion) and Italy (EUR1.4 billion) and others.

Take the Banca d’Italia (BdI). While they would make a loss on monetary income due to transactions with domestic banks for monetary policy purposes, in fact they will still make a profit of about EUR0.8 billion. This is possible because they receive about EUR1.4 billion in transfers from the rest of the Eurosystem. This covers their “profit” from system-wide monetary policy as well as funding necessary transfers to the Italian banking system of EUR0.6 billion on roughly 36bps TLTRO2 outstanding net of excess liquidity taxed at 40bps.

In other words, until Thursday Core banks were making transfers to those in the Periphery. But NCBs were making positive monetary income, notwithstanding these concealed transfers.

What is the impact of Thursday’s policy announcement? Let’s assume TLTRO2s are rolled over in full into TLTRO3s, and that bank lending targets are met 100%. And let’s assume the current distribution of liquidity is unchanged (i.e., don’t contemplate additional APP purchases for now, or capital flows within the system.) Then the impact on income and transfers across the Eurosystem is shown on the right side of Figure 2. With tiering of six times required reserves—set at 0%–there is no longer any income from this source. Moreover, the cost of TLTROs has increased as the deposit rate has been reduced to minus 50bps.

Crucially, the main impact if that the overall profit in the system is reduced EUR2.7 billion, from EUR4.6 billion to EUR1.9 billion. As such, the resources available for NCB profits, other things equal, is reduced.

Moreover, curiously, the size of the transfers from creditor to debtor within the Eurosystem actually increases. Why? Because Spain and Italy now don’t generate any income on excess liquidity, in fact they need to receive larger transfers from the system in the context of sharing monetary income to fund the payments to their banks from TLTRO3 as well as zero income on excess reserves.

Indeed, Figure 3 shows how Thursday’s announcement, other things equal, benefits banks by country and impacts intra-system transfers relative to the baseline. Banks in Germany benefit about EUR650 million (per year) while Bundesbank profits decrease about EUR700 million. The difference is larger transfers to the system as a whole as additional transfers, mainly from France, are needed to Italy and Spain.

Screen Shot 2019-09-15 at 21.33.29Perhaps the most important point to note here is that the new policy measures mainly act to reduce NCB monetary income. Given many NCBs will soon—if not already—face negative income on holdings and rollover of PSPP portfolios, which will be a drag on profits, this further threatens income and capital in the future.

In other words, the policy change has served to transfer income from Eurosystem income to the banking system.

And most important, since the interest rate on tiering is distinct from the MRO rate, this can be increased in the future to create additional income for banks at the expense of NCB capital—to improve profitability and, hopefully, increase net lending in pursuit of the inflation target. To this end, Figure 4 below provides a number of scenarios, calculating the monetary income for the aggregate Eurosystem as a function of the tiering ratio—starting from 0, i.e., no tiering, to 15, though chosen at 6 last Thursday.

Screen Shot 2019-09-15 at 21.33.35

(As an aside, it seems clear why the initial tiering ratio of 6 was chosen. In my model, this generates savings to banks of EUR3.6 billion, which is almost exactly the same as the rollover of EUR693 billion of TLTROs at -50bps.)

While the current system, without tiering, generates income for the Eurosystem, tiering creates the possibility that the system as a whole receives negative income from monetary policy actions. For example, with a deposit rate of -50bps and tiering rate of +50bps, then a tiering ratio above 10, there would be negative income for the Eurosystem as a whole. In other words, monetary policy would require NCBs to run down capital to transfer to the banking system to encourage lending and meet the inflation target.

(We ought note there are other, non-monetary sources of income—as well as possible coupons on APP purchases. But the trend towards running down NCB capital in pursuit of monetary stability is clear.)

More realistically, at the existing tiering ratio of 6, a TRR of +100bps with deposit rate unchanged would generate negative income for the Eurosystem of about EUR5 billion per year.

Screen Shot 2019-09-15 at 21.33.43

For this case, Figure 5 illustrates the impact on income and transfers across the Eurosystem given the existing distribution of liquidity. Since the system as a whole makes a loss, it is this loss which is now shared across the Eurosystem. However, peripheral banks are still in receipt of income due to both TLTRO3s and that due to tiered reserves. As a result, some of the income on non-tiered reserves from the Core is transferred to the Periphery still—Core banks are still subsidizing their Periphery counterparts.

Meanwhile, there are more extreme outcomes, of course. See Figure 6. Imagine the deposit rate at -100bps with TRR at +100bps. And suppose the Tiering Ratio is increased to 10 times required reserves, with existing liquidity distribution. Then we are again in a world where NCBs make losses on monetary income. But here, for Core central banks, this negative income goes to pay domestic banks for their use of the Tiered Reserves as well as transfer to Peripheral banks for the same purposes. Thus, NCBs are running down their capital to provide income for the domestic banking system—and in the case of the Bundesbank subsidize peripheral central banks’ income and banking systems.

Of course, none of the above reflects on the possibility of a growing balance sheet of the Eurosystem as a whole, or indeed the future distribution of reserves—and TARGET2 balances. Even with TLTRO rollover and repayment on schedule, and with currency in circulation growing at nearly 5% per year, APP purchases of EUR20 billion per month would drive excess liquidity near EUR2.8 trillion by end-2030 (that is, EUR1 trillion above today’s levels.) The distribution of this liquidity, and associated TARGET2 balances, will become increasingly important in determining the relative transfers between NCBs and the overall income of the system.

Screen Shot 2019-09-15 at 21.34.11

Should core inflation continue to fall short of target, this raises the concern that open-ended APP with possible increases in the TRR will create losses for NCBs—eroding capital in pursuit of price stability.

Thus the creation of a new interest rate—the TRR—alongside potentially open-ended APP generates many more possibilities for sharing of income or the erosion of NCB capital.

That Draghi laid down such stringent conditions for the withdrawal of exceptional monetary policy measures last week suggests he is tying the hands of his successors—to make sure they cannot back down from the pursuit of price stability. Doing so, he is not only suggesting to fiscal policymakers it’s time to take up the burden of macroeconomic management—but without this there will be quasi-fiscal losses through NCBs, as well as growing quasi-fiscal transfers across the system. Better to make these fiscal measures explicit and generous than feeble and hidden.

And central bank governors hate making losses. They are political beasts, many with political ambitions. To be reporting losses year-in-year out, and to be seem as part of a hidden transfer union will be uncomfortable for many—or most.

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The fact that, by re-weighted capital key, at least 55.8% of central bank Governors were in some way opposed to the announcement last week (Germany, France, Austria, Netherlands, and Estonia) is suggestive. Add to this two members of the Executive Board, and there is a considerable faction against Draghi’s latest policy wheeze. Is it the open-endedness of proposed APP that matters? Or the new TRR that could generate losses for NCBs in the future? Or the combination of the two? Not clear.

In summary, understanding the quasi-fiscal flows throughout the Eurosystem and the available future policy tools just got much more difficult—and interesting. Bring it on.


Goodbye IMF, hello ECB. But what’s the quid pro quo?


WHEN FRENCH POLICE searched the Paris home of then-International Monetary Fund (IMF) Managing Director Christine Lagarde in March 2013, an undated, handwritten pledge of allegiance from Lagarde to former President Nicolas Sarkozy was uncovered. Later leaked to the press, the letter—presumably written while he was still President—urged Sarkozy to “use me for as long as it suits you and suits your plans and casting call.”

The pretext for the raid on Lagarde’s home was, of course, the investigation into possible misuse of public funds—more than €400 million—in settling a claim on the state by Sarkozy-supporting, French businessman Bernard Tapie. Eventually, Lagarde was found “guilty of negligence in public office” for settling the case, but absent a sentence or formal criminal record from the finding by a special Paris court in December 2016, her position as IMF Managing Director was unthreatened.

When asked in court why she had not read detailed briefing that described the history of the Tapie case alongside a recommendation to rule out arbitration, Lagarde’s reply was that she “received between 8,000 to 9,000 notes per year.” In her overall defense, Lagarde implied she was not on top of her brief, was a mere pawn in the heady world of French politics, and was in any case happy to defer to her chief of staff on this decision—and likewise happy for him to take the blame in court.

What does this glimpse into the world of Madam Lagarde reveal about the person set to become the President of the European Central Bank (ECB)?

LAGARDE ARRIVED at the IMF in July 2011, about a year before the euroarea crisis peaked. Retrospectives on her contribution to the Fund will be cast in terms of charisma and statesmanship, as well as her contributions to the empowerment of women—it’s impossible to scan an IMF document today without stumbling upon measures to improve female labor force participation. However, an honest assessment of her tenure would recall those issues that most define her time at the Fund: austerity in the UK and Brexit; the Greek great depression; the Cyprus deposit insurance debacle; flawed euroarea oversight; and Argentina’s crisis renewed. There is a common denominator in all these cases—deeply flawed analysis driven by, or coupled with, politically-motivated decision-making. In all cases Lagarde was found out of her depth. In most cases, there appears to be a quid pro quo behind decisions. Her appointment to the ECB therefore represents a dangerous, perhaps seminal moment for the euroarea.

WHEN THE time came to nominate a new Managing Director in May 2011, it was not a euroarea member state making the case for Lagarde at the IMF. Rather, it was United Kingdom (UK) Chancellor of the Exchequer and austerity advocate George Osborne who formally nominated Lagarde in May 2011. And when Lagarde was up for a renewed term in 2016 it was Osborne again who quickly advanced re-nomination just months before the UK’s EU Referendum. Why was Lagarde’s candidacy so important to Osborne?

In 2010, as the coalition government in the UK had begun a policy of fiscal consolidation, the IMF under previous Managing Director Struss-Kahn had fallen under the austerity spell. The Fund produced saccharine analysis on the pros and cons of fiscal adjustment in that year’s Article IV consultation—the oversight of the UK economy conducted annually by the IMF. And the IMF was happy to conclude: “After weighing these different arguments [for and against austerity]… a significant fiscal tightening with frontloading in 2011/12 is appropriate to secure confidence in the UK’s debt sustainability” (Box 2, page 27.) This endorsement was exactly what Osborne needed; an IMF challenge to his strategy would be a tough pill to swallow. DSK’s unexpected departure could make the next annual health-check awkward, therefore—unless a suitable replacement could be found.

In throwing his weight behind Lagarde, Osborne was buying continued support for his policies—and would be able to call in any other favors along the way. Following her appointment as Managing Director, Madam Lagarde was duly on hand to add sparkle to the press conference at the end of the next Article IV visit in 2012, offering support to the “Chancellor, dear George.” The stomach turns.

The IMF’s endorsement of austerity in the UK thus continued despite hardships owing to the regressive nature of the adjustment including due to falling public investment—while continuing net inward migration diluted available public services. Moreover, as is now increasingly appreciated, austerity was not necessary at all—it was a political choice.

Spin ahead a few years, and Osborne had a bigger favor to ask. The decision to hold an EU Referendum in June 2016 required “objective” analysis that would point towards the benefits of Remain—Osborne’s position. In a series of clearly political interventions, the Fund’s Article IVconcluding statement in May 2016 was timed to coincide with the final month of the campaign; Lagarde was again on hand to deliver a carefully scripted message that led some to claim the IMF was “bullying” voters; while the publication of the Article IV report itself, just one week before the referendum, was surely timed to grab headlines and impact the vote.

Even if the IMF should to have strong views on these matters—and they should—delivery ought not be staged-managed for political favors. And the analysis itself should not be driven by political considerations. In any case, after the IMF’s wrong-headed support of austerity in the UK, why should anyone believe their analysis? The marginal voter in the EU Referendum, we might speculate, was likely most negatively impacted by the very same austerity the IMF was previously happy to endorse on Osborne’s behalf. Once bitten, twice shy. And when a prominent Leave campaigner suggested the UK public had “had enough of experts,” one wonders if the IMF was one of the targets. Only a few months later, the IMF was said to be “left shamefaced” over their flawed forecasts leading up to the EU Referendum.

THE FAILURE in Greece was a scandal on a different level, of course. The IMF was hardly a deciding factor in the EU Referendum in the United Kingdom. But the Fund was certainly central to the Greek great depression. And the program’s failure was assured before the ink on the document was dry. In short, the May 2010 adjustment assumed with no justification that Greek exports of goods and serviceswouldexpand65% through 2015 (imports would growonly5%)so exports as a share of GDP wouldincrease from 17.8% to 27.7% in six years. This 65% increase in nominal Greek exports over six years, necessary to offset domestic demand compression and retain the illusion of “debt sustainability,”would be achieved through both real exports and the price of the Greek export basket. That is, 39 percentage points of growth was penciled indue to real export growth (Staff Report 10/110, p.10), the remainder due to price increases—roughly a 3% per year average increase in the export price deflator over the period, despite so-called “internal devaluation.”

Moreover, although general government interest expenditure, mainly due to external debt,was expected toincrease from 5% of GDP in 2009 to projected 8.1% in 2015 (10/110, p.13), net interest in the external current account did not involve an equivalent deterioration.

It was later revealed  by veteran IMF-watcher Paul Blustein that a memo from the Research Department before the Greece program was finalized correctly warned that the “program could still go off track (even with full policy compliance)” absent “strong export rebound.” So, some staff warned about the egregious assumptions—beyond the control of the Greek authorities—upon which the program hinged. But the program went ahead regardless.

Yet, taken together, the GDP and external factor income assumptions at the time of the initial program impliedthat, to sustain domestic demandand repay debt, the people of Greece wouldgenerate external income of more than €30 billion per year by 2015, or roughly 13% of initial GDP. This was against a backdrop of substantial, coordinated fiscal tightening across Europe—and growing risk of euroarea disintegration.

To simply assume the Greeks could magic euros from thin air was ridiculous—a scandal seldom been before seen in the history of official action in international monetary affairs except, perhaps, the German reparations imposition. Moreover, the attitude of official creditors was like that of a loan shark—repayment terms were impossible to meet, but if the Greeks failed to deliver they would be punished by ever-greater bullying and onerous impositions.

All this was pre-Lagarde-as-MD, of course—though coincident with her time as French Finance Minister. Upon appointment at the Fund, Lagarde faced a choice. She could have asserted the independence of mind to rethink the Greek situation—and defend the Greeks as Managing Director of the multilateral body inaugurated after the Second World War to lend to countries“by making the general resources of the Fund temporarily available … without resorting to measures destructive of national or international prosperity.” Or she could side with euroarea creditors against the Greeks. And she very publicly chose the latter.

To begin with, when debt restructuring was finally broached in late-2011 and 2012, the IMF capitulated to official creditors and allowed the ECB and national central banks (NCBs) to swap their €56½ billion holdings of Greek government bonds into new titles so they could be exempted from restructuring. This increased possible private sector losses in the restructuring—and later, the quasi-fiscal, thus unseen, transfers from taxpayers through lower interest costs. Doing do, it also reduced the potency of Eurosystem purchases—prior or prospective—in other countries. It hinted at greater private sector losses in future if needed, perhaps contributing to financial instability. It thus later became necessary to clarify that official holdings would be treated the same as private investors later under the ECB’s Asset Purchase Program (APP), underlining the sensitivity of the matter for investors. But when it came to Greece, narrow political constraints overwhelmed decisions needed for system wide stability and recovery of a very depressed economy. Given IMF support was necessary for continued Northern European involvement in the program, there was plenty of leverage to force a better deal for the Greeks.

The problem was, the Fund under Lagarde had chosen to demonize the Greeks rather than rethink the flawed macroeconomic logic that underpinned the so-called adjustment program. Indeed, even after the PSI operation, an investor visiting Athens in summer 2012 was not encouraged to be met by the IMF’s then-Resident Representative—and person responsible as desk economist for the original, incoherent program—explaining that “as long as this place is not burning to the ground, we’ll keep turning the screw,” a sentiment accompanied by a hand gesture to emphasize the point. This would hardly catalyze private investment! This was hardly the spirit of Fund lending without recourse to measures destructive of prosperity!

But the remark made perfect sense in the context of comments only a few months before, shortly after the flawed debt restructuring, when Lagarde herself explained to the Guardian that “she has more sympathy for children deprived of decent schooling in sub-Saharan Africa than for many of those facing poverty in Athens.” This attitude demonstrated a willingness to overlook entirely those analytical flaws in the original Greece program, as well as the IMF’s Purposes, to instead push a message from political masters in Europe. Indeed, this mirrored exactly the attitude later recalled by former Treasury Secretary Timothy Geithner, that the Europeans’ in early-2010 “we’re going to teach the Greeks a lesson.”

A braver, intellectually independent Managing Director would have noted the impossible assumptions upon which the original Greek program was based—and asserted the primacy of the IMF’s own mandate over that of European institutions. A more thoughtful leader would have taken a stand against the Northern European bullying and argued for stronger and more immediate debt relief.

WHEN GREEK debt restructuring finally arrived in 2012, several Cypriot banks were left overexposed, undercapitalized, and essentially bankrupt. By early-2013, a newly elected center-right President Nicos Anastasiades paved the way for a Troika program to restore financial stability after vacillating by his predecessor. By this time, however, the IMF’s involvement in euroarea lending programs had become increasingly controversial amongst non-EU members of the Executive Board. Moreover, unlike in the case of Ireland, there was now pressure from Core euroarea countries to bail-in the private sector to cover banking sector losses. Perhaps most important, Germany did not want to be seen to use taxpayer money to “bailout rich Russian depositors” as veteran IMF reporter Paul Blustein has explained. Indeed, as Blustein continued, German Finance Minister Wolfgang “Schauble insisted on limiting the size of the loan package to €10 billion; the remaining €7 billion [of financing] needed for the banks would have to come from their depositors and other Cypriot sources.” This is even though debt sustainability would have seen Cypriot public debt on a substantially more favorable trajectory than many other euroarea program countries. Crucially, Lagarde aligned once more with European creditors.

Regardless of the merits of the choice between bail-in and bail-out—and there is a case to be made that bail-in should not have been countenanced for financial stability reasons given public debt sustainability was not a major concern, — once that decision was taken what happened next should neverhave been allowed to happen. In short, the IMF’s initial proposal to bring sustainability to Cyprus involved losses for bondholders and large depositors—which would be transferred along with troubled assets to a “bad bank” and face losses of perhaps 40%. But the EU Commission was worried about the spillovers due to such large losses while the Cypriot authorities thought it might undermine their role as offshore financial center. Thus, the Commission, in the form of Olli Rehn, proposed a series of taxes on large-, medium-, and small deposits to fill the gap. The problem being, small deposits included those subject to deposit insurance.

Now, deposit insurance has been sacrosanct for financial stability since the Great Depression in the United States, when the Federal Deposit Insurance Corporation (FDIC) was inaugurated to stop bank runs and stabilize the banking system. Most countries developed their own deposit insurance schemes since, including across the euroarea where deposits under €100,000 were supposed to be insured. But in Brussels, as negotiations over Cyprus continued throughout the night—at the first key meeting chaired by recently appointed Eurogroup President, Jeromin Dijsselbloem—there was no-one apparently willing to speak up against breaking the deposit insurance taboo and associated implications for the rest of the euroarea. By the end of the night, under the strain of deadline, an agreement was reached which would tax deposits below €100,000 at 6.75%. The read-across to the rest of the euroarea was clear—all deposits were fair game to restore sustainability to the fiscal-financial sector. The risk of deposit flight was immediately elevated.

Fortunately, the Cypriot legislature refused to vote through the deal, and the damage was quickly undone. But this was a truly breathtaking failure of global macroeconomic policymaking. Blustein described it thus: “It was one of the starkest examples in financial-crisis history of how highly intelligent people can make decisions under pressure in the middle of the night that look appallingly unwise in the light of day.”

Put another way, it’s an example of how the blinkered objectives of interlocutors—each with their own narrow negotiating brief—can result in a dangerously suboptimal compromise with global implications. In this case, the IMF was more concerned about dotting the i’s and crossing the t’s in a pro formadebt sustainability exercise—which happened to justify the German need for a private bail-in—while reducing the IMF’s reputational risk by putting a lower proportion of the bail-out money forward. In the scrum to achieve these narrow negotiating objectives to please different constituencies, Lagarde took her eye off the big picture.

Any IMF Managing Director who allowed this to pass ought to have been sacked the next morning. But Lagarde could always blame the Europeans—or her staff; the Europeans could always blame the Cypriots; the Cypriots could blame the Greeks; the Greeks could blame financial market ebullience—and before you know it, no one is to blame.

Of course, this was not the first time Lagarde had been close to decisions that jolted financial markets over the course of the euroarea crisis. It is not clear what role Lagarde played in the background to the Deauville declaration in October 2010, while French Finance Minister. But it was in Deauville that Chancellor Merkel and President Sarkozy bilaterally agreed—that is, without consultation with other member states—that future bailouts would involve private sector haircuts, contributing to the intensification of the euroarea crisis. It’s difficult to imagine the two Finance Ministries were not involved.

THERE WERE in fact two periods of coordinated monetary-fiscal tightening in the euroarea over the period 2010-14, which left an imprint globally via the value of the euro. The first was intended, the second due to a bug in emergency monetary measures.

In 2011, under President Trichet, the ECB began tightening monetary policy, raising the main policy rate from 1% to 1.25% in April, and a further 0.25% to 1.5% in August—despite ongoing coordinated fiscal consolidation. And IMF staff were on hand in July, shortly after Lagarde’s arrival at the Fund, to support this egregious policy tightening. “The outlook calls for a gradual withdrawal of monetary stimulus,” the surveillance report insisted.

Within months, of course, this premature policy tightening was withdrawn by incoming President Draghi—while a series of Very Long Term Repo Operations (VLTROs) were implemented in December 2011 and March 2012. Under the pre-text of heading off a bank funding hump, these VLTROs bought some crucial time for euroarea peripheral governments—by loosening the balance of payments contraint temporarily. But it would eventually take Draghi’s “whatever it takes” moment in the summer of 2012 to reserve capital flight related to fears that the euroarea would indeed dissolve.

As capital inflows resumed to the periphery in the second half of 2012, banks were once again able to access private funding. And a key problem with VLTROs was that they allowed early, voluntary repayment. They were not “outside money” to the financial system, as with standard Quantitative Easing, but were “inside money”—simultaneously both an asset and liability of the banking system. So, with enhanced liquidity, euroarea banks—perhaps to signal their access to private funding—began repaying these borrowed reserves. This brought about the endogenous tightening of monetary conditions—as base money and excess liquidity contracted, EONIA increased and the euro appreciated. This monetary tightening was entirely preventable. But it took the associated euro appreciation and disinflation pressure for the ECB to act through a series of exceptional measures in 2014 and 2015—from negative interest rates to APP.

The result of this monetary loosening and endogenous tightening was that the euro depreciated nearly 15% against the dollar between end-2010 and mid-2012 as fears about the euro area emerged. It then appreciated on endogenous tightening through early-2014. This was followed by a sharp depreciation as deflation risk emerged and investors began to factor in exceptional policy support. The euroweaked 15% in real effective terms and 21½%  against the dollar since end-2010.


The Fund was largely a champion of fiscal consolidation throughout this period, only in recent years encouraging fiscal expansion. Still, the impact on the euro of the monetary reaction falls squarely within the IMF’s mandate. How has the Fund throughout Lagarde’s term assessed the euro exchange rate? The table below summarizes the conclusions on the external value of the euro since 2009, taken from the euroarea surveillance report each year, as the euroarea current account went from near balance to about 3% of GDP on peripheral depression and flawed fiscal response.


What is most striking is how difficult it has been for Fund staff to provide a proper assessment of the euro exchange rate. Even in 2015 and 2016, with sharp depreciation as monetary policy strained to offset the distortions imparted by flawed fiscal policies, staff considered the euro as “broadly consistent with medium-term fundamentals.” This policy action impacted the rest of the world largely through the weak euro, of course. And one of the IMF’s core functions under the Second Amendment to the Articles of Agreement is the assessment of policies as they impact others through the exchange rate. This is not to claim that exceptionally loose monetary policy was inappropriate, only that a more thoughtful assessment of deflationary global spillovers through the currency would have helped underline the true cause of this problem in fiscal policy.

MOST RECENT has been the IMF’s intervention in Argentina. Unlike Greece, this is entirely on Lagarde’s watch. But like Greece, it is defined by the primacy of politics over analysis in program design.

For several years prior to the IMF’s latest involvement in Argentina, the government leaned on the central bank (BCRA) to finance growing fiscal deficits. For example, as well as purchasing government debt directly, BCRA was transferring profits to the government throughout. However, the central bank had negative net income throughout. How was BCRA making profits then? Due to Peso depreciation which created paper gains on foreign exchange reserves. And so, as the currency depreciated, BCRA would make paper gains that would serve as the basis for cash transfers to the government. Since 2011, BCRA transferred ARS375 billion in profit to the government, averaging 0.9% of GDP per year all the while BCRA capital was shrinking from 1.4% of GDP in 2011 to 0.7% of GDP in 2017.

In fact, BCRA did not even have income to pay for administration costs and the printing of paper currency, so would create base money for this purpose as well. Overall, to prevent the impact on base money from this and other transfers to the government, BCRA would issue interest bearing securities. But absent the real resources to finance these sterilization operations, the central bank had to resort to either printing more money to pay the interest on these or issue ever greater securities in a monetary policy Ponzi scheme.

The overall fiscal and quasi-fiscal position was much worse than the IMF acknowledged at program outset, therefore. The interest bill on BCRA securities more than 2% of GDP, a hidden fiscal deficit. But the program proceeded as if this was of no importance when assessing fiscal sustainability. The recapitalization of BCRA—a known and possibly substantial fiscal cost—was acknowledged, but was only to be completed by end-2019. Moreover, monetary policy proceeded by increasing interest rates without recognizing that this would either bring future monetization and exchange rate risk, or an additional impact on fiscal sustainability to be later realized. Investors meanwhile proceeded as if these quasi-fiscal risks did not exist.

These challenges were known in advance—or could have been known with the forensic analysis of monetary-fiscal interactions. And addressing them early as prior actions when building the program would have triggered early either debt reprofiling or restructuring. Instead, the Argentine authorities leaned on the Trump administration; the US Treasury leaned on the Fund; Lagarde waved through largest program in IMF history—potentially USD57 billion, of which about USD44 billion has been disbursed—based on a monetary policy Ponzi scheme.

WHAT DO these serious cases have in common? They are all characterized by deeply flawed macroeconomics and political influence on decision-making—and there is typically a quid pro quo involved. For Osborne, Lagarde delivered on austerity and Brexit analysis in the joint pursuit of his political goals and her career ambitions. In Greece and Cyprus, Lagarde sided with Germany throughout—allowing deeply flawed analysis to pass her desk to keep the Greeks under the European thumb and impose costs on the Cypriot taxpayer. In exchange, it was widely rumored Lagarde was under consideration for a European Commission role in 2014—but was ultimately still needed in DC. When it came to analysis of the euroarea, the IMF has been incapable of balanced assessment of fiscal-monetary policies; the assessment of the euro has been stale and thoughtless throughout. But this was necessary so that German fiscal policy would not be under scrutiny, ingratiating herself with Chancellor Merkel. In the case of Argentina, despite being castigated for being under political influence throughout the euroarea crisis, Lagarde was found under the influence of the US Treasury in signing off on a program that hinged on a continuing monetary policy Ponzi scheme.

BEFORE LAGARDE at the IMF there was Dominique Strauss-Kahn (DSK) of course. And DSK perfectly set the tone for Lagarde’s time at the Fund.

Strauss-Kahn was commonly expected to use his time at the Fund as a springboard to the French Presidency, dethroning Sarkozy. Indeed, during his successful bid to become Managing Director in 2008, Strauss-Kahn employed Paris-based public relations firm Euro RSCG (as then called) to manage his image. Then, upon DSK taking the job, the IMF immediately “hired two big-name PR agencies to help spread the Fund’s message” as Reuters explained in August 2008. These two contracts were said to be worth between $1.5 million and $2.0 million—an unusual expenditure at exactly the time the Fund was trying to cut costs by $100 million per year. Though everyone turned a blind eye, one of the firms chosen was the very same Euro RSCG—the company that supported DSK’s campaign, a firm run by friends of Strauss-Kahn, the same friends who were amongst the first to visit him when on bail following allegations of sexual assault.

The awarding of such large contracts strongly hinted at DSK’s desire to use his position at the IMF to forge his image and further his political ambitions in France—a stealth campaign from the relative distance of DC. But it also smelt strongly like misuse of public funds.

How would Sarkozy respond to this growing threat from across the Atlantic? According to the retelling of the circumstances surrounding DSK’s arrest in New York City in May 2011, there are secret recordings of Strauss-Kahn discussing his candidacy with friends just days before his arrest. DSK was perhaps being monitored by the French secret service, his actions potentially relayed directly back to Sarkozy. Moreover, it is possible that DSK’s criminal actions that day were orchestrated at Sarkozy’s request to explicitly disqualify Strauss-Kahn from the French Presidential race—if true, a remarkable intervention in global governance, at a pivotal moment in the euroarea crisis, for purely domestic political reasons by a European sovereign.

Put another way, DSK’s tenure underscored how European politicians have never been interested with what they can do for the IMF, only what the IMF can do for them.

Following in DSK’s footsteps, Lagarde has levered her time at the Fund to promote her career within European institutions. Being asked to replace Draghi as President of the ECB would appear to reward fealty, sycophantism, and analytical incompetence. These are not qualities that the most senior monetary policy position in the euroarea requires.

There are three arguments surrounding Lagarde’s ECB appointment that we might dismiss based on her track record.

First, Lagarde is a continuation of the status quo—and therefore a dovish replacement for the current President. Honestly, this we do not know. She was as supportive of Trichet’s failed policies as she was of Draghi’s enlightened interventions. She has no track record in monetary decision-making, and has shown no command over the intricacies of central bank balance sheet interactions and financial superstructures. And those decisions she has been involved in during the euroarea crisis were often destabilizing.

Second, Lagarde will be able to bring her political gifts to command greater monetary-fiscal coordination. In fact, her record in terms of holding euroarea creditors to account demonstrates nothing but fiscal conservatism. Moreover, her written answers responding to the European Parliament questions before her formal appointment exhibits no appetite to challenge the deflationary fiscal bias in the euroarea—beyond supporting a future centralized fiscal resource.

Third, technical staff will keep Lagarde on the straight and narrow. More likely, she will promote those staff who provide the analysis needed to advance her own personal objectives or help deliver on some political side-deal or other.

Overall, the biggest risk to the euroarea today is the unknown—and unknowable—quid pro quo that might underpin the decision to appoint Lagarde to replace Draghi or might emerge in the future as the new President plans her own future. If Lagarde sees her tenure at the ECB as a stepping stone to something more—she will be in her early-70s by the end of her term, meaning there is still time to become, perhaps, the first euroarea Finance Minister or take another elder statesperson role—then monetary policy over the next 8 years can easily come under political influence. And the assumption that Lagarde is a like-for-like replacement of Draghi is a huge misreading of her track-record.


What to expect from Argentina’s 5th Review debt sustainability analysis

What can we expect of Argentina’s 5th program review? We are told the IMF team arrived in Buenos Areas on Saturday. Presumably the objective is to complete this review by end-September—as this review will be judged against the end-June program targets, already passed. IMF funds can be released before the election, therefore. The implications of the election can be dealt with later. This is the right decision, in my view—despite the challenges facing Argentina. The global community owes Argentina some forbearance.

Still, what might be the new path for public debt-to-GDP in the 5thReview? This depends on the politics driving the optics of requiring debt-to-GDP at 60% by the end-forecast horizon. The table below summarizes assumptions that underpinned the 4thReview. The IMF already implicitly assumed ARS would reach 49.4 by year-end, so had factored in some depreciation. Then again, even at ARS55 we are 10% weaker still. The recent exchange rate move with large liability dollarization throws the previous DSA out the window. The Fund also assumed an increasing share of ARS denominated debt over the forecast horizon and low effective interest rates on Federal debt—with negative real yields driving down debt-to-GDP.


How might these assumptions change? Let’s knock out our own projections and see where this takes us. Let’s assume ARS sits at 55 through September, depreciates 2% a month through end-2020, 1% a month through 2022, and ½% a month thereafter. This gives us a new path for end-year ARS as shown in the table below. These new assumptions see ARS reach 99.8 by end-2024, compared with 79.5 implicit in the IMF’s 4thReview.


How might this translate into GDP deflator? The chart below demonstrates congruence between exchange rate depreciations in Argentina and changes in the GDP deflator—and the lag is slight. It also shows a projection for the GDP deflator which assumes a generous spread for the GDP deflator relative to ARS depreciation ahead.


This translates into a secular increase in the ratio of the GDP deflator-to-ARS, returning to levels seen in 2017 by 2025, as shown below—arguably a period of overvaluation, but let’s ignore that.


In addition, let’s assume 1% contraction in GDP for this quarter and the next, 0% growth each quarter next year, and 1% quarterly growth thereafter (more generous than the IMF’s 4thReview in later years, perhaps too generous compared to reality near-term).

How does this convert into a revised path for nominal GDP? This is shown in the table below. Two things are worth emphasizing. First, nominal GDP in ARS is barely changed in 2020 despite the additional ARS depreciation here. This is because the IMF are far too generous in their GDP deflator assumptions—driving down debt-to-GDP. This alternative GDP is roughly unchanged relative to the 4thReview for 2020 despite sharper ARS depreciation. That said, in later years GDP in local currency increases above the 4threview assumptions—though not in USD. According to this new projection, USD value of GDP fails to surpass 2017 levels by 2024.


This takes us some way to generating a revised debt path. We need to address the issues of interest and the primary balance.

On the interest bill, it’s anyone’s guess at this point. For example, between the 3rd and 4th Review, the expected interest bill for the first 6 months of 2019 in the fiscal financing tables was substantially reduced. At the time of the 3rdReview, the 2019H1 interest bill was projected at USD10bn. By the 4thReview this had been reduced to USD7.3bn, with the financial and nonfinancial public sector contributing 90% of this lower interest burden. At the same time, there was an increase in projected amortization over the same period of USD1.6bn—of which public sector amortisation contributed 84% of this increase. It’s as if public sector bodies had been asked to reduce recorded interest paid by the Federal government and roll this into amortization—certainly this is how the BCRA “profit transfer” of end-May was treated. This presumably allows the Federal government to show a lower fiscal deficit for the year due to a lower interest bill, contributing to favourable debt dynamics. Note also, the 4thReview effective interest paid in 2019 was expected to be 5.5%—ridiculously low for one of the world’s least creditworthy governments—increasing to only 10.9% by 2022.

If the authorities, with IMF consent, are willing to play such games with the fiscal numbers, it’s difficult to pre-empt what they might cook up for optical purposes. Instead, let’s call bullshit and simply add 200bps to the 4thReview interest rate assumptions throughout—this being still incredibly generous in my view given ongoing institutional malaise and necessary monetisation. There is a case to increase the interest bill further, but let’s overlook this.

As to the primary balance, let’s assume a deficit this year of 1%, 0% next year, and 1% surplus thereafter. Perhaps.

Anyway, the final assumption necessary is the currency composition of debt. Let’s assume local currency debt stays constant in % of GDP, with FX issuances making up the rest.

With these assumptions—not, admittedly, a true bottom up DSA, rather top-down—where do we end up? The chart below contrasts the 4thReview with these revised assumptions. While the 4thReview could show a monotonic reduction in the debt-to-GDP from 2018, our alternative sees debt increase near-term, beyond which it falls. But debt-to-GDP still sits above 75% by 2024.

ARS6The key reasons for the less favourable debt dynamics are the less ebullient GDP deflator, the higher interest rate, and the larger share of fx denominated debt. It’s worth emphasizing again this is more back-of-the-envelope than bottom up analysis. But sometimes simplicity delivers clarity.

That said, I would expect the IMF to continue to use the GDP deflator and interest rate assumptions to deliver a more favourable debt path to the above—coming in closer to 70% of GDP by 2024, perhaps.

Regardless, none of this addresses the need for BCRA recapitalization. Absent this institutional imperative there will be continued monetary instability. This will be addressed after the election, should the program continue. And it will add materially to the ratio of public debt-to-GDP. Given the implied interest on BCRA liabilities of more than 2% of GDP currently, once this is dealt with public debt will look even less favourable, and the prospects for sustainability eroded further—sensible restructuring will have to factor this in.

Finally, this does not factor in the challenge of rebuilding international reserves. Sustainability for Argentina should consolidate the Federal government with BCRA, not only to deliver sustainable monetary policy, but as corollary to uncover a path for balance of payments that might—at last—bring about fiscal-financial stability. This ought to be an explicit concern in program design, but remains elusive. This underscores the inadequacy of the IMF’s debt sustainability framework, and the risks investors in Argentina continue to take.

But even the above would allow the IMF to continue to engage with Argentina until the election is over.


Argentina’s monetary meltdown: What policy reaction function?

BCRA meltdown pdf.

The Central Bank of the Argentine Republic (BCRA) provides, with a short lag, updates on daily contributions to the change in Peso (ARS) base money. With this, BCRA on Thursday offered a glimpse into their reaction function in response to the acute market pressures that followed the primary election outcome. What can be learnt from this experience?

First, local LELIQ claims on BCRA are flighty. In short, ARS257bn of LELIQs were maturing on Monday 12th August; together with interest (annualized at 62.6%) of roughly ARS3bn this provided a rollover need of perhaps ARS260bn to neutralize the impact on base money. However, they were only able to rollover ARS100bn in LELIQ (at 74.8%.) And so, they replaced less than 40% of the LELIQs falling due. Most (but not all) of the rest contributed to the expansion of base money from ARS1,345bn outstanding as of Friday to ARS1,487bn on Monday.

Second, BCRA is willing to intervene on the spot market. For the first time under the latest monetary leg of the program, BCRA engaged in spot market intervention…

Third, that said, BCRA is very reluctant to run down gross reserves to protect ARS. Total spot intervention on Monday amounted to USD105mn. Let’s guess at an average intra-day exchange rate on Monday of, say, ARS55—doesn’t matter much in the grand scheme of things. That amounts to roughly ARS6 billion sterilization. And so, of the ARS160bn of LELIQs not rolled over—most of which presumably sought refuge in foreign exchange—less than than 4% was sterilized through intervention.

What sterilization was permitted under the IMF program? Some intra-marginal spot market intervention was allowed, but never acted upon. Most important, once the upper band of ARS51.5 was reached, BCRA might “be prepared to sell up to US$250 million (an increase from the previously announced US$150 daily limit) and may undertake additional interventions to counteract episodes of excessive volatility.”

If last Monday does not meet the definition of excessive volatility, then nothing does.

Thus, despite extraordinary market volatility, BCRA remained largely passive—utilizing less than 50% of the permitted intervention margin under the program. Why? Let’s imagine BCRA were to choose to defend the upper band supposed under the program and sterilize all the LELIQs that failed to rollover. At the upper bound of ARS51.5, this would imply running down about USD3.1bn of gross international reserves to defend the currency. What does BCRA’s external position look like? Figure 1 provides the answer, plotting Gross International Reserves (GIR) since end-March 2018. GIR was USD61.5bn before pressures began in April 2018. Today’s GIR is barely changed at about USD65bn. On the face it, BCRA has a war chest to defend ARS. However, this overlooks the massive official support that has been provided over this period. Figure 1 also shows cumulative IMF (USD44bn) and China swap line (USD8.5bn) support over this period as well as GIR net of this support. This net reserve measure reached USD12.5bn as of Tuesday. In addition, there is a legacy swap line from China believed to be around USD12bn, meaning that the true net reserves figure is roughly zero. (Note, BCRA external loans were reported at USD21.8bn as of end-2019Q1, which is mostly these PBOC swap lines.)

Screen Shot 2019-08-17 at 14.13.19


This helps frame BCRA reluctance to make use of gross reserves to defend the currency—even if USD3bn seems small in relation to their reported gross reserves, the true external position is much weaker than this. And USD3 billion would have driven the net reserves position so measured negative.

As a caveat, the true consolidated government external position should allow for Federal debt as well as external assets. External assets are minimal, while non-IMF external debt was about USD130bn as of end-2019Q1.So the consolidated State net external position is likely around minus USD130bn.

Finally, we should note that BCRA also intervened on Tuesday last week in the amount of USD150mn—so more than during Monday’s meltdown, and USD255mn in two days. Meanwhile, LELIQ rollovers were resumed at reasonable levels, but at an interest rate of about 75% annualized.