11 January 2019

Financial Times: The euro already has a safe asset

[...]The eurozone already has a safe asset. It is issued by the European Central Bank, and takes the form of central bank money. Banks can hold deposits with the ECB, which are, by definition, as safe as any euro-denominated asset can be. The total amount of central bank reserves that banks can hold on deposit with the ECB is, of course, limited by their supply, but that is true of conventional safe assets as well. And the rate paid on central bank reserves may not be to banks’ satisfaction (it is currently negative), but that, too, is true of the bonds of governments with their own currency.

ECB reserves do, however, lack some features of the conventional safe asset in national economies. The first difference is that central bank reserves do not have a maturity structure, as government debts do. That means government bonds of different maturities help build up a whole yield curve of risk-free rates.

The other difference is that this safe asset — ECB reserves — is only available to eurozone banks, not to financial markets in general. Government bonds are, in contrast, available to any interested buyer.

These shortcomings prevent central bank reserves from playing the anchoring role in the eurozone that government debt plays in other economies. But both are easily remedied. The ECB could offer time deposits of varying maturities, which would immediately create a yield curve of safe eurozone assets. Central bankers have acknowledged this. In a 2016 speech at Jackson Hole, Benoît Cœuré of the ECB executive board expressed his clear preference for governments to issue safe assets to meet any shortage in the markets, but added: “If this does not happen, central banks may have to use their own balance sheets to satisfy safe asset demand, also at longer maturities.” Cœuré added further reflections in a speech at Harvard later the same year.

The ECB could also make central bank deposits available to all financial market participants, or at least a much wider circle of financial institutions than today, which would open up the pool of safe assets to meet the demand for it. Long-term time deposits could take the form of tradable bonds, or otherwise be designed so that holders could pledge them as security for loans, like sovereign bonds are used for collateralised borrowing today.

In fact, there is no better time to begin planning such a facility than today. The ECB has stopped adding to its stock of sovereign bonds, and is contemplating a future “quantitative tightening” for when it judges that some of the money it created in the process of its easing programme should be taken out of the economy. But that tightening is something it could achieve by issuing its own safe assets to mop up market liquidity it deems excessive.

What would this do? If there is indeed a shortage of safe euro assets, there presumably will be a flow of money into any new ones created. Eurozone governments may worry that the market will dump their own bonds, preferring ECB time deposits, which would raise their borrowing costs. But if markets price investments off the back of the new common safe asset, this presents its own solution: the ECB can adjust the rates on its time deposits to guide market interest rates to where it thinks the economy needs them to be.

What about inflows from abroad? The offer of a safe long-term asset may well make the euro more attractive as a global reserve currency, something Europeans have long wished for. That means the euro’s value could be pushed up, which would make eurozone exports more expensive and increase import demand. That is something other countries have long wished for. If this damps economic activity in the eurozone, the ECB and governments have the tools to stimulate domestic demand as well.

Indeed, greater control of the yield curve increases the ECB’s power. Central banks directly target short-term interest rates; through their bond-buying they also influence long-term rates. But among big countries, only the Bank of Japan has explicitly targeted the long-term rate, and no central bank has accepted that if it directly targets both short and long rates, the yield curve itself becomes an instrument it can use to influence economic conditions. The ECB can now be a pioneer in more ways than one. It should grasp its chance.

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