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ECB Bini-Smaghi:Bond Buys Aimed to Restore Dysfunctional Mkts

Published Tuesday, 15th June 2010 09:01 am - © 2010 MNI News

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FRANKFURT (MNI) - The European Central Bank's government bond buying program is aimed at restoring monetary policy transmission and is "not to finance public debt," ECB Executive Board member Lorenzo Bini-Smaghi said Monday. "We intervene in euro area public and private debt securities markets in order to ensure depth and liquidity in those market segments which have proved dysfunctional," Bini-Smaghi said in the text of a speech prepared for delivery at Barclays Global Inflation Conference in New York.

"As government securities are the basis for pricing all private debt instruments, our action in the sovereign bond markets aims to create the orderly conditions necessary for lenders to provide a steady flow of credit to the private economy," he added.

Given increased risk aversion, demand for securitization should increase further and sovereign debt will "probably replace [asset-backed securities] in the collateralization of secured lending," Bini-Smaghi said. Looking ahead, sovereign debt will "certainly be widespread," he added.

However, he said that while sovereign securities "used to be considered risk-free assets," in the future "the risk characteristics of this type of debt instrument will be more graduated than was considered possible only few years ago."

Since the central bank will stand strong in ensuring its prime mandate of price stability and will not allow government debt to be inflated away, countries with sound finances will benefit from lower risk premia while those living above their means will have to pay up, Bini Smaghi said.

"In Europe's Monetary Union, the central bank is as strong and institutionally established as the fiscal authority. If the fiscal side does not adjust, inflation risk mutates into liquidity risk. In the most severe cases, if the fiscal adjustment is delayed, liquidity risk turns into solvency risk," Bini-Smaghi said.

"Countries with comparatively better-managed public finances will pay lower risk premia, and therefore lower interest rates, which, in turn, will help them to keep budget deficits and the stocks of national debt under control," he said.

By contrast, "countries with larger budget deficits and higher stocks of national debt, on the other hand, will face higher risk premia, and therefore higher interest rates, which, in turn, will affect their ability to control the dynamics of their public finances," Bini-Smaghi added.

Given the rising importance of sovereign debt, its primary role as collateral used for central bank refi operations is unlikely to diminish so the central bank "will continue to emphasize strongly the maintenance of orderly market conditions for this type of instrument," Bini-Smaghi said.

In this context, the ECB's collateral rules may have to be reconsidered once more, he added.

"When a central bank provides credit against collateral, it must follow up with a frequent re-evaluation of the credit conditions so as to safeguard its funds and make sure its commitment is not abused. Also, by the very act of declaring an asset eligible for monetary policy operations, a central bank has to be aware that it might affect its price," Bini-Smaghi said.

"This argues in favor of a graduated system of collateral valuation, in which haircuts reflect the underlying fair value along a continuous scale, possibly with less threshold discontinuity than at present. These are issues for further analysis," he said.

Bini-Smaghi also said the current crisis may permanently change the monetary policy tools of central banks but emphasized that they will continue to pursue the same objective of price stability.

During the course of the financial crisis, the ECB has replaced ill-functioning segments of the financial market and acted as an 'intermediary' between banks with a liquidity deficit and banks with a liquidity surplus, Bini-Smaghi said.

This experience may have shown banks "that they could manage their liquidity requirements -- perhaps more comfortably and at lower cost -- through central bank intermediation rather than via their traditional money market activities," he observed.

"Central banks -- for their part -- have seen that their collateralized lending has made them key market makers at a time when markets were disappearing," Bini-Smaghi said.

"In light of all these developments we may well ask whether the new market-making role of central banks will continue," he said.

While "it is too early to say" whether the ECB will keep a more important intermediary role in future, Bini-Smaghi said that it would be a trade-off between positives -- such as more stability and more private lending -- and well as negatives -- such as crowding out of markets and less incentives to reduce liquidity risks.

Even of the role of central banks does change permanently, "they have to remain inflexible in their overall strategy," Bini-Smaghi said.

"In a changing financial environment the only way to maintain credibility is to safeguard the ultimate objective, which is price stability," he asserted.

--Frankfurt bureau tel.: +49 69 720 142. Email:

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