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ECB to pay interest on government deposits, easing bond squeeze fears

·2-min read
FILE PHOTO: European flags are seen in front of the ECB building, in Frankfurt

By Yoruk Bahceli and Francesco Canepa

FRANKFURT (Reuters) -The European Central Bank (ECB) said on Thursday it would start paying interest on government deposits, easing fears that euro zone countries would shift the cash into government bonds, worsening a shortage of key market collateral.

Starting on Sept 14, euro zone government cash balances at their national central banks will accrue interest at the ECB's deposit rate, which was raised to 0.75% on Thursday, or the overnight rate ESTR, whichever is lower, removing a 0% cap.

Analysts had warned that if the 0% cap remained after Thursday's rate hike, it would have incentivized government debt offices to cut some of their cash balances at their central banks. Those cash balances currently amount to some 600 billion euros ($598 billion), according to ING Bank.

To do that, debt offices would have taken more collateral, in the form of high quality debt, out of the market - exacerbating a bond shortage after years of ECB asset-buying that has sharply reduced the free float available to investors.

A further bond squeeze would have put downward pressure on overnight rates, hindering the transmission of ECB rate hikes into the financial system.

A particular concern was that debt offices would stop lending out their bonds in return for cash through repurchase agreements, or repos, or conduct reverse repos, where they lend cash in return for bonds.

"This change will prevent an abrupt outflow of deposits into the market, at a time when some segments of the euro area repo markets are showing signs of collateral scarcity," the ECB said.

Euro zone bond yields surged following the announcement and German two-year yields rose to the highest since 2011.

The lending of bonds to investors in the repo market is a crucial part of market infrastructure. It has been critical for investors this year as benchmark issuer Germany has increased lending given a worsening bond shortage.

If the 0% cap had remained after Thursday's widely anticipated ECB rate hike, such lending would have led to a loss for debt offices, leading them to run down cash, analysts said.

Such worries had widened the spread between interest rate swaps and short-dated bond yields this week to levels not seen since the euro zone debt crisis.

Following the ECB decision, the Dutch finance ministry said it would not change its cash management policy until the end of the new remuneration policy, which will run until April 30, 2023, and work on a new strategy for thereafter.

Even with Thursday's move, analysts expected demand for higher-rates bonds to use as collateral to remain high.

"Demand for collateral is likely to remain elevated despite today's announcement," said Francesco Maria Di Bella, fixed income strategist at UniCredit.

(Reporting by Yoruk Bahceli and Francesco CanepaAdditional reporting by Stefano RebaudoEditing by Mark Potter)