LONDON: Once again markets are rallying on the basis that policymakers will do what is necessary. But if there has been one lesson throughout the crisis it has been that liquidity-based solutions are ineffective when credit risk is the dominant concern. There is sufficient liquidity in the markets; it's just that due to credit risk the price of this liquidity is too high. The price is high due to credit risk whether one looks at the European sovereigns or its banks.
The co-ordinated move to lower the ceiling for the price of liquidity faced by banks when borrowing dollars from 100bps to 50bps over OIS is positive and well overdue (IFR has been calling for it since September).
As is the haircut faced by banks who borrow against eligible collateral from 20 percent to 12 percent. However, this still leaves us with a stigma effect whereby any uptick in borrowing will lead to a witch-hunt which will inject more volatility and risk into the market.
The only real solution is for policymakers to start to take risk out of the market, as opposed to trying to rely on liquidity provisions alone and hope that animal spirits will work their magic. We have seen from the data obtained by Bloomberg the extent to which the Fed was willing to step in and extract credit risk from the market and onto its own books following the collapse of Lehman. It is time for the ECB to step up and throw away its aversion to printing money and start to more actively take sovereign and financial risk from the markets.
At its meeting next week the ECB may try to stick to its old tools of liquidity-based measures by offering loans of up to 3-years and also relax collateral rules by accepting foreign currency denominated assets.
However, this is not enough, and it is now time to be more active and, 1) lend out high quality ECB paper against sovereign and financial paper, 2) step up its purchases under SMP, 3) be willing to either directly fund the EFSF or indirectly fund it via the IMF and allow a bigger role as a firebreak.
Liquidity-based action from central banks can buy time, and European politicians also need to act fast on reaching a consensus as to where they want to go. This is no time for dithering.
Markets dislike uncertainty and the AAA countries should make clear at the EU summit on Dec 9 that; 1) sovereignty over fiscal policy will be lost for those who fail to stick to targets, and if this is not acceptable then the exit doors are wide open; 2) sovereigns unable to meet sustainability goals will undergo immediate debt restructuring and; 3) financials-banks will be recapitalised and those deemed to be insolvent will be nationalised. All of the above can be made possible by an EFSF that is fully backed by the ECB.
Without addressing market concerns over the solvency of sovereigns or financials/banks, any liquidity-based solution from the ECB (or Fed) will only provide limited relief.
The current rally on risk has the potential to continue heading into the EU summit next week, but coming out of it we could be back to 'risk-off' very quickly should there be a lack of follow-through action from politicians.
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