The Truth About The ECB's Plans To 'Sterilize' Its Purchases Of Government Debt

Mario Draghi ECB press conference

Photo: ECB

When the ECB announced its new plan to buy peripheral government debt in Europe (for the purpose of reducing yields) there was some concern over the fact that the purchases were going to be “sterilized.”In theory what this means is that if, say, the ECB goes out and buys 50 billion EUR worth of sovereign debt, then somewhere else it will remove 50 billion EUR from the system so as to avoid inflation (and placate the Germans).

Some people wondered: What assets will the ECB sell in order to finance these purchases.

But the market was clearly not worried about this sterilization news, as evidenced by the big market surge on Thursday and Friday, as investors realised that “sterilization” is mostly for show, with little real impact on the amount of money in the system.

In a note from last December, JPM’s Greg Fuzesi explained how the ECB engaged in bond sterilization (this was in reference to the old SMP program, but the gist is the same.

When the ECB purchases peripheral government bonds through its Securities Markets Programme (SMP), it pays for these by creating new bank reserves (i.e., through the modern form of printing money). In terms of its balance sheet, both assets and liabilities increase. The purchased peripheral bonds are held as assets in the SMP category and are matched on the liability side by a larger amount of bank reserves. In the first instance, the new reserves are added to the current accounts that commercial banks hold at the ECB. In this form, the reserves are fully liquid as they count towards meeting banks’ reserve requirements and they can be used to settle interbank payments.

The way the ECB has chosen to sterilize these reserves balances is to encourage banks to shift them from the fully liquid current accounts into fixed term deposits, which are just another form of reserves. The ECB could offer these at any maturity but has chosen a short maturity of just one week (likely for operational reasons). The deposits are auc- tioned through a tender procedure, which requires banks put in bids, stating the amount they are willing to tie down for the one week period and the interest rate at which they are willing to do so. The maximum interest rate that the ECB is willing to pay is the main policy interest rate, and it be- gins by picking the cheapest bids until it has met its target level.

So basically, the “sterilization” just means that banks commit to keep some cash at the ECB for a fixed period of time, so it doesn’t technically enter the system. And since that money at the ECB is liquid and guaranteed it’s not a problem.

As for whether the sterilization really matters, the answer is: Not really.

First, it does not shrink the ECB’s balance sheet back to its original size, as would be the case if the ECB sold other assets to finance its SMP purchases. It is of course debatable whether a larger central bank balance sheet is a source of concern per se (e.g., of the inflationary sort). But, even if it is, the sterilization method used by the ECB clearly does not address this concern.

Second, viewed from the perspective of the banking system, purchases of peripheral government bonds by the central bank remove a risky asset and replace it permanently with highly liquid reserves (whether these are subsequently sterilized or not). In addition, the sterilization operation ties the funds down for only a very short one-week period and these can still be used as collateral at other ECB refi- nancing operations. Hence, the sterilization itself does not neutralize the impact on the banking system’s balance sheet, which has become permanently more liquid. Whether this, in itself, encourages banks to lever up in other ways (e.g., by making other risky investments or aggressively growing their loan books) is debatable. But, in any case, the sterilization does not fully reverse the changes.

So it’s just technical accounting stuff. The ECB can buy unlimited volumes of sovereign debt, provided the country whose debt its buying remains in good compliance with reforms.

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