Euro zone excess liquidity to halve this week, adding to ECB conundrum

FRANKFURT Tue Jan 7, 2014 9:45am EST

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FRANKFURT Jan 7 (Reuters) - The amount of excess cash in the euro zone financial system is likely to nearly halve this week as banks take up less European Central Bank funds, pushing up money market rates and putting pressure on the ECB to take action to stop that rise.

Higher money market rates effectively tighten monetary conditions, which the ECB loosened only in November by cutting its refinancing rate to a record low of 0.25 percent.

The ECB meets on Thursday, and while it is widely expected to take no action this time, it will be keeping a close eye on the money market as well as on weak inflation.

While lenders relying less on central bank cash generally indicates that money market tensions have eased, the resulting drop in liquidity also pushes up market rates, which if prolonged could hamper the economic recovery.

"There are worries that liquidity will wilt away, and this means that the ECB could have to take action," Nordea analyst Jan von Gerich said.

On Tuesday, banks took 112.5 billion euros ($153.5 billion) in the ECB's main weekly refinancing operation - 56 billion euros less than the week before, when they were stocking up for the tense end-of-the-year period.

The ECB also successfully drained funds to offset government bonds bought under its now-ended bond-buying programme, after three consecutive failures. Banks will deposit 179 billion euros at the ECB for a week - 74 billion euros more than in the previous operation on Dec. 30.

This all means that on Wednesday, when these transactions are settled, euro zone money markets will be down by 130 billion euros, which could mean excess liquidity - the amount of money in the market beyond what banks need for their day-to-day operations - falls to about 150 billion euros from the current 277 billion.

"While one week does not fundamentally change the tone, this confirms the direction of earlier last year," von Gerich said.

In a Reuters poll last month, 25 of 40 respondents said the ECB would increase liquidity through a third long-term loan, probably early in 2014.

"The ECB will see no need to act (this month), but will think of options, such as a targeted long-term liquidity operation," von Gerich said. "It won't take much in the way of bad news for the ECB to act."

Euro zone inflation fell in December after a small increase the previous month, adding to the challenge the ECB faces in avoiding deflation while supporting the bloc's recovery.

ECB President Mario Draghi has said that if the central bank did inject more cash, it would have to ensure that any additional long-term money is not just used to buy government debt, as it was when the ECB poured in more than 1 trillion euros in two operations in late 2011 and early 2012.

Other options for the ECB include cutting interest rates, taking its deposit rate into negative territory or no longer offsetting its bond purchases, which would add 179 billion euros to the market immediately, or cutting its reserve requirements.

In November and December, when excess liquidity also fell to around 150 billion euros, short-term market interest rates rose. That trend could resume, especially when voluntary paybacks of three-year central bank loans resume next week.

The ECB's twin three-year cash operations in late 2011 and early 2012 helped push up excess liquidity to more than 800 billion euros.

Those loans will expire in about a year's time, but banks have used the early repayment option and returned almost half the money to the ECB already. ($1 = 0.7330 euros) (Reporting by Sakari Suoninen; Editing by Hugh Lawson)

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