Today the ECB has finally arrived as a truly “European” Central Bank. It has acted against political opposition to deliver what is by most measures an ambitious programme of quantitative easing. The programme exceeded the predictions of most market participants and analysts, and it lies at the edge of our optimistic predictions.
In short, Mario Draghi has finally delivered on his “Whatever it Takes” pledge. But suffice to say that this QE will not, by itself, be sufficient to deliver on the ECB’s own target. The ECB has finally, if belatedly, done its part. Now its time for the Eurozone to relax the fiscal constraint.
Objective
The programme is as open ended in terms of delivering on the ECB’s core target of inflation “close to but under 2%”, as it was politically possible for the ECB to be and promises action all the way into September 2016.
How much
The ECB has committed to buy Euro 60 bn of assets per month for “at least” 18 months or just over Euro 1.1 trillion, but this includes expanded existing programs on covered bonds as well as asset backed securities.
The ECB will seek to achieve its inflation target with the programme, but the programme is not “open ended”. But for the most part, particularly also based on the experience of the US Fed, we should expect the ECB QE to continue in the foreseeable future.
The ECB will reach its target Euro 3 trillion balance sheet size by mid 2016.
This still falls far short of the balance sheets of the US Fed and the Bank of England (relative to GDP), but that means that September 2016 may not see the end of QE.
What will it buy?
The ECB will buy bonds of EU institutions such as the EIB. It will also buy investment grade sovereign bonds and will likely retain some discretion on the reactive size of these purchases, though sovereign bonds are likely to constitute around 2/3 of the total volume. EU institution assets will be roughly Euro 7 billion a month.
It will continue to purchase, in increased quantities, the asset backed securities as well as the covered bonds that it already buys.
Together these will add up to roughly Euro 60 billion per month.
It is somewhat disappointing that the programme does not extend to corporate bonds, equities and other more exotic assets such as SME Loan portfolios that can have a more direct impact on the real economy, but these might be indirectly captured (not equities) within the expanded asset backed security program.
The fact that the ECB would target bonds with maturities from 2-30 years is good news, as it will have an effect on the yield curve across the board and also help facilitate the use of long-term financing for projects such as infrastructure. The fear was that the ECB would limit itself to buying bonds with less than 10 year maturity. Previous purchases under the SMP and OMT were limited to shorter maturities. Even then, we expect most ECB purchases to be in the 5-10 year bracket.
The distribution of asset purchases was also somewhat disappointing, as the ECB would have got more bang for the buck by buying more assets in crisis hit economies. Basing the purchases on capital key will mean that the biggest purchases will be that of German bunds that already have negative yields.
The ECB will limit itself to no more than 33% of any issuer bonds and no more than 25% of any particular issue of bonds to avoid excessive concentration and crowding out and distortion in the markets which is sensible and non-binding for most important assets and countries.
That thing about risk sharing
On risk sharing, the purchase of bonds of European institutions such as the EIB will be on the Eurosystem balance sheet, just as most previous purchases including those under SMP have been. Of the rest, the ECB will hold 8% of the newly bought assets on its own balance sheet but the rest will be on the balance sheets of the National Central Banks. Conceptually, this is also how the Emergency Lending Assistance (ELA) facilities used in Ireland, Greece and Cyprus were structured.
While there was a lot of concern on this lack of risk sharing, as we explained in our previous note, this concern is overdone. For all intents and purposes and under the present context where most eurozone economies (with the exception of Greece and maybe Cyprus) are far from default, this is immaterial.
What was very important was that Draghi also clearly highlighted that the OMT, the Outright Monetary Purchase programme the ECB announced in 2012 (but never activated) still exists as a backstop in the event of renewed market panic of the kind seen in 2012. Under that, Draghi said, the risk pooling arrangements will be intact.
How will this QE work? What are some more details on why risk pooling is not that critical? For this and more, please read our longer companion piece published just before the ECB announcement.
Sony Kapoor is the Managing Director of Re-Define and a Senior Visiting Fellow at the London School of Economics