Arbitrage through the ECB

Here is the new short-term auction of Italian debt:

The debt sold at 3.251 percent, sharply down from 6.504 percent at a previous auction in late November. Demand was 1.7 times the amount on offer, compared with 1.47 times previously.

Of course it is the long-term debt auction, due tomorrow, which is going to matter.  Here is a very good Edward Hugh essay on Italy.


Tyler, there's a big difference between an arbitrage and a simple carry trade.

The Hugh essay in Roubini's Economonitor is pretty good, but for the sectors, like construction and services, where there is probably a high underreporting of income for tax avoidance purposes, I wonder how meaningful the productivity statistics are. Since some of these events are state finance crises, it is interesting how quickly Monti is taking steps to crack down on a very high rate of tax avoidance, second only to Greece. Perhaps part of a sovereign debt crisis during a recession is that more people practice tax avoidance, it becomes the norm, weakening sovereign finances even more than that caused by a recession.

"Demand was 1.7 times the amount on offer, compared with 1.47 times previously."

What does this mean? I thought that demand was dependent on price, not just some fixed number. Wouldn't the quantity demanded be equal to the "amount on offer" in an auction that clears?

I think it means that the aggregate amounts of bids were 1.7 times and 1.47 times, respectively, the volumes of the two bond issues offered. The highest bids (lowest rates) bought bonds.

I'm upset. I pay 2.625% and 3.25% on two adjustable-rate real esate loans.
I'm a much better credit than Italy.

What is this, to fund 6-months of debt?

Possibly sales are resultant of banks (523 accessed $640 billion in recent Long-Term Refinancing Operation) awash with liquidity and needing to earn a spread on money that remained after paying deposit withdrawals.

Long-term Refinancing Operation – LIQUIDITY – not a solution to the crisis. Three-year low interest funding; taking PIIGS debt instruments as collateral; highlights severity of crisis; temporarily eases fears about banks; low cost funds locked in three years. This expanded ECB assets and the eurozone monetary base – rate cuts.

Additionally, the Fed opened the spigots to eurozone (US taxpayers inidrectly propping up European capitalists) via euor/dollar swaps. US taxpayer is indirectly at risk. Fed reduced rates charged to 0.6% and extended maturities. This shrunk Fed’s spread to 0.34% from 0.84% - no room for loan loss provisions. Swaps/loans at $85 billion, which pales in comparison to $600 billion in 2008.

I think it is solvency for our time.

Now, let's all go home and have a nice quiet sleep.

It has taken awhile, but maybe the markets have finally taken notice of two salient facts: 1) Italy is running a primary budget surplus, and 2) Berlusconi really is finally gone.

On the Hugh piece:

1. Wages in manufacturing in Italy are about 50% of German wages, while German manufacturing does wel...
2. Public sector wages in Italy (excluding education, by the way) are actually higher than in Germany (Eurostat).

The point: Unit Labor Cost are a very bad statistic to investigate comeptitiveness. It's just the labor share in income, a macro statistic that's usefull to investigate macro questions, but not to ivestigate micro questions! See also Krugman's post on the same problem with Ireland.

Daniel Gros also has a usefull post on Voxeu in which he shows that the only Italian metric which is really deteriorating is corruption. Which calls for quite a different policy than the macro data.

By the way: when you look at the export and import data of European countries it in fact shows that Germany did not do that well, compared with for example Spain or Portugal. When it comes to extra-european exports, Spain and Portugal even did quite a bit better. The difference is that German imports increased much less. Just like the Italian ones. Competitivety of these PIIGS seems allright, looking at export data - the difference is that domestic consumption in Italy and Germany hardly increased, post 2000, which led to low import growth. Again: we should not confuse micro with macro. Except for growth, the italian macro data are not that bad. The Italian problem is that the ECB engineered high interest rates which disabled the rolling over of debt. And of course the corruption thing, mentioned by Gros, which might be the real reason for dismal growth performance.

An alternative to the arbitrage theory...

The new ECB collateral rules dramatically increase the quantity of assets that banks can submit to the ECB in order to get ECB clearing balances. Bank loans are now allowed, so are lower quality ABS. This means that it is less likely that the national governments will have to guarantee local bank debt. This was a real problem in Greece and Ireland, for instance, for the local banks had run out of assets to submit to the ECB. Instead, banks were creating debts amongst each other and having the government guarantee these debts, before submitting them to the ECB as collateral.

Since private non-marketable debt can now be submitted to the ECB, governments will no longer be required to covertly bail out their banks by guaranteeing intra-bank debts. That means that euro government debt is now a lot safer, and explains why yields are falling. So you can use an ECB arbitrage theory to explain the data, but there are alternatives.

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