Sterilization of central bank intervention: concept, methods and questions in the context of the ECB’s MTO.

When Mario Draghi announced the OMT (Outright Monetary Transactions)[1] on September 6, he stated his intention to sterilize any bond purchases made under the program. The aim of this article is to clarify this concept and its application in a general context, before going on to discuss this operation and its possible limits for the ECB in the present case (the informed reader can skip to the latter part).

Sterilizing an intervention avoids the associated inflationary pressures

Sterilizing an intervention means withdrawing the liquidity injected into the system as part of that intervention. In general, this concept is used in the context of foreign exchange intervention: the central bank buys foreign currencies in order to prevent the appreciation of its currency (in simple terms, it’s supply and demand), and as it doesn’t want to add liquidity to the market, it withdraws it. In recent times, this concept has been increasingly used in the context of unconventional monetary policies, as the major central banks have purchased assets that play a strategic role (directly or indirectly) in the transmission of their monetary policy. Sterilizing these interventions helps to avoid a liquidity surplus that could have undesirable consequences. Such excess liquidity could, for example, lead to a fall in the interbank interest rate, with the latter moving significantly away from the central bank’s target interest rate[2]. Or, more simply, the danger is that this liquidity could « circulate » in the economy, fuelling inflation.

Various theoretical courses of action

Central banks have a number of tools at their disposal, often little described in the literature:

– selling other assets in parallel: this technique is often used in currency intervention. By selling assets (often highly liquid assets such as treasury bills), the central bank removes liquidity from the market. The disadvantage of this method is that interest rates on government bonds (if these are the assets chosen, which is generally the case) are likely to rise, thereby attracting a certain amount of new capital seeking to take advantage of these rate movements unrelated to economic fundamentals. According to IMF economist Jang-Yung Lee, this latter situation tends to render interventions of this type ineffective in emerging countries (where government debt is not very large in volume).

In the case of the ECB’s OMT, this type of sterilization is not conceivable, as the ECB is not strictly speaking authorized to hold government securities on its balance sheet[3].

– increase the minimum reserve ratio[4], currently at 1% in the eurozone. This method of sterilization has been used extensively in China, following the country’s substantial accumulation of foreign exchange reserves (now approaching 20%). The advantage of this solution is its effectiveness, the disadvantage is that it affects banks’ credit supply much more directly than other methods.

– Issue sterilization bonds: in this case, the central bank issues debt directly. The cost of this debt is normally very similar to that of government debt (in theory, its lower liquidity means that it has a spread of a few points over government debt). China’s central bank has also used this technique extensively with its commercial banks, in a more or less coercive manner… This solution, to which the markets are not accustomed, would perhaps have a cost in terms of image and credibility if the ECB were to apply it.

– reverse repo operations: in the context of relations between commercial banks and central banks, this operation corresponds to the same thing as a repo[5], but seen from the other direction. The difference with the sale of securities is that, in theory, it has no bearish effect on the markets.

– by offering financial intermediaries interest-bearing accounts on which to place their cash (fixed-term deposits that cannot be withdrawn within a given period). This is the method chosen by the ECB in the context of the SMP (which continues to be applied today) and which is likely to be chosen once again. In the case of the ECB, it is important to note that these fixed deposits are eligible as collateral, and that the funding of these deposits is carried out by auction at variable bid rates, with a current maximum rate of 0.75%.

From a theoretical point of view, other more indirect methods (insofar as they are not necessarily implemented for this purpose) could be mentioned, such as credit capping (used in China).

The case of ECB OMT sterilization

Most analysts suggest that the ECB will continue to use the method of inducing banks to deposit their liquidity in a term deposit (weekly until now under the SMP). If this is the method chosen, it should give rise to some of the questions needed to understand the credibility of the commitment.
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In the past, the ECB has in fact failed in some of its sterilization operations, failing to encourage banks to deposit enough of their money for a weekly period. This was the case in May 2010, when the ECB was supposed to sterilize 203.5 billion euros, but only managed to attract 194.2 billion euros. While some saw this as a sign of a possible limit to the amounts sterilized via this technique, others considered the failure irrelevant, as it was due to a temporary lack of liquidity on the part of the banks. Since then, this problem has not arisen, and when we look at the ECB’s September 2012 statistical bulletin[6], we see that since May, unsecured liquidity operations have had an average coverage ratio of around 2, with a low of 1.37 at the end of June 2012 and a high of 2.3 at the beginning of September.

In fact, it’s not clear how far the ECB could go in terms of sterilization, depending on both the method it uses and the financial context. While for the ECB, distributing liquidity on the one hand (via the OMT) and taking it back on the other (via sterilization) may appear to have a neutral impact, this is not at all the case for banks, for whom selling securities may be beneficial, while placing the liquidity thus obtained at a rate close to the refi rate for a weekly period may not be optimal in the context of their overall strategy. While it is true that banks currently have considerable liquidity, some of which they can do without (total excess reserves and liquidity placed with the deposit facility amounted to some 800 billion euros at the beginning of September), the situation could be different in a few months’ time, particularly in the event of premature LTRO repayment and a return to financial tensions. As a result, complete sterilization may prove difficult.

The question of the feasibility and modalities of sterilization associated with the OMT should therefore be asked more in the context of triggering the OMT. Depending on the modalities chosen, it is conceivable that the sterilization of OMTs, if the ECB makes it a matter of principle, could call into question the « unlimited » nature of the program (or else will have to be accompanied by other measures) and thus undermine its credibility. Perhaps this is one of the reasons why Mario Draghi did not elaborate on this issue?

References

ECB’s failure to sterilize bond purchase is a red herring, JP Morgan Economics Research Note December 2, 2011
Sterilizing Capital Inflows, Jang-Yung Lee, IMF Economic Issues 7, February 1997
Gang Fan’s article on monetary sterilization in China: http://lecercle.lesechos.fr/leseconomistes/autres-auteurs/221132127/lasterilisation-monetaire-de-la-chine