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: frankfurt@marketnews.com

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