What will the ECB announce today?
The ECB will announce broad outlines of a programme of Quantitative Easing today. The programme itself will focus on the ECB buying large quantities of financial assets, mostly Eurozone sovereign bonds, with freshly created money. The actual purchases will start in March and more details of the programme are likely to follow over the next few weeks.
What is the objective of this programme?
The stated objective of the programme is to increase Eurozone inflation from the dismally low level of 0.6% (in 2014) towards the ECB target of “close to but below 2%”. In December, inflation in the Eurozone actually turned negative at – 0.3% and longer-term market expectations of inflation have also been falling for several months now.
The ECB hopes that the QE will also have a direct impact on increasing investment and consumption in the Eurozone and thus help give a boost to growth. The combination of higher real growth as well as higher inflation, the ECB hopes, will also help improve the sustainability of debt in the troubled countries in the Eurozone.
How is it supposed to work?
The ECB hopes this will be achieved through multiple channels. The most important, in the near term, is perhaps through a depreciation of the Euro, much of it has already happened in anticipation of the QE announcement. This increases the prices of imported goods and services and would give a short term boost to inflation.
The depreciation will itself probably happen through a reallocation of some of the funds freed when the ECB buys Eurozone assets from investors to non-Eurozone assets creating an outflow of funds from the Eurozone and into dollars and other currencies. It was in anticipation of this that the Swiss National Bank gave up trying to defend a cap of 1.20 against the Euro.
Two other financial impacts of QE are also important: Portfolio reallocation to private Eurozone assets to help increase and wealth effects that help stimulate consumption.
Since the largest component of the ECB purchases will actually be relatively safe sovereign bonds, the ECB hopes that some of the reallocation will be towards riskier assets such as corporate bonds as well as equities within the Eurozone thus improving the financing conditions for investments. Low sovereign spreads and interest cost savings (as interest paid by sovereigns to the ECB on bonds eventually comes back to the sovereigns themselves through the annual distribution of ECB profits) may also help increase the space for much needed public investments.
To the extent the ECB itself, as we have suggested, buys more private assets such as corporate bonds, packed SME loans and even perhaps equities, the effect on private investment can be even more direct.
The second financial impact is through the wealth effect wherein once the ECB starts buying existing financial assets, the price of these is likely to rise and this will help increase the paper wealth of existing asset holders. This will make them feel richer and they are likely to spend more.
However, one of the most critical channels, particularly in the Eurozone, is confidence. The Eurozone has suffered from the lack of a sensible and unified political response and from what is now widely understood to be an incomplete institutional structure. The ECB, by doing QE even in the face of German opposition, will once again signal that it is a truly pan-European institution that is willing to stick its neck out to help provide a boost to the Eurozone economy. This will make both Eurozone citizens as well as foreign entities doing business here more confident about the integrity of the Eurozone and its longer term prospects.
This would also announce the arrival of the ECB into the category of a more normal central bank that also has a lender of last resort function. It is also likely to have a positive effect on inflation expectations over and above what the direct financial channels alone can achieve.
In summary, while the ECB will formally target increasing inflation and inflation expectations, in reality it hopes that QE will boost confidence, investments and growth in the Eurozone and that the combination of higher inflation and faster growth will also make Eurozone debts more sustainable.
How big will it be?
The ideal announcement would mirror what the US Fed did and make an open-ended commitment to QE until the inflation target is hit. This will be politically controversial and even in economic terms it is far from clear, as seen in Japan, if QE itself can deliver the inflation target.
At the other end of the spectrum, the ECB would commit to new purchases of a fixed sum, say, between Euro 500 bn and Euro 750 bn or a fixed amount of monthly purchases, mostly likely to be Euro 50 bn for a fixed length of time.
In the end, the ECB is likely to combine elements of all three and announce a fudge along the lines of “purchases of Euro 50 bn/ month for 15-18 months while regularly reviewing effects and progress towards our inflation goals”. It will leave scope for further action, but will not make an open-ended commitment. This euro 750 bn QE target is also compatible with the ECB’s stated goal of restoring its balance sheet to about Euro 1 trillion when put together with the ECB’s existing programs on covered bonds and asset backed securities.
The ECB will not commit to Euro 1 trillion of new purchases, but the sum of existing and new programs will be made to approach this level, particularly if they are expanded.
Would this be enough? In order to reach the same size of the balance sheet as a percentage of GDP as the US fed or the Bank of England the ECB needs to do more – as much as Euro 2 – 3 trillion of QE – not just 1 trillion. This is not an objective the ECB will pursue now, despite the Eurozone economy and inflation expectations being in worse shape in the Eurozone than in the US or in the UK. But this does leave the door open for further action.
In summary, the ECB is likely to announce buying Euro 50 bn or so of securities starting March for another 15-18 months for a headline number of about Euro 750 bn. Together with the existing programs on covered bond purchases as well as asset backed securities the ECB is likely to announce a headline amount of Euro 1 trillion. This is also consistent with the ECB’s sated goal of increasing its balance sheet to Euro 3 trillion.
What will the ECB buy?
When the US and UK undertook QE the economic context was different and the most recent bout of Japanese QE is also not strictly comparable. What is clear, however, is that the likely shape and size of ECB QE will be more conservative than what has been undertaken elsewhere.
The Eurozone does not have as well developed capital markets as the US, so the range of assets the ECB can buy is more limited.
Three considerations drive which assets the ECB should buy. Ideally, the asset class ought to be liquid (ie easy-to-purchase), efficient (ie deliver the biggest bang for the buck on inflation and the real economy) and large enough to be macro-economically significant.
Politics dictates that the programme should be symmetrically designed (open to all countries), but economics calls for an asymmetric impact in crisis countries, this is more assets should be bought in fragile economies.
Unfortunately, no asset class fulfills all criteria.
Large-scale purchases of government bonds, which is on the cards this week, will definitely help; but the biggest impact on the real economy will come only if the fiscal space this provides is actually used to borrow and invest. For this, the provisions of the Stability and Growth pact will need to be relaxed.
The recently agreed purchase of asset-backed securities (ABS) provides a more direct channel to the real economy but the market is small compared to the size of asset purchases necessary. The ECB reported that it has only been able to buy only about € 2 bn of these ABSs so far thus limiting their impact. Ongoing covered-bond purchases by the ECB have been larger at just over € 30 bn and are useful, though perhaps less efficient than ABS in terms of the impact on the real economy. They are also limited in size and the biggest issuance comes from Germany (though Spain, France and Italy would also benefit). The purchase of EIB securities to fund an investment programme, as suggested by some economists, is efficient but won’t be big enough on its own. It is possible, that the ECB may extend its asset purchases to include EIB bonds when it announces the details of its QE program on Thursday.
The recently launched ECB Targeted Long-Term Refinance Operation (TLTRO), whilst not strictly QE, will also help by providing lower interest loans to banks to lend into the real economy. But its effectiveness is hampered by a banking system that, despite passing the ECB’s asset-quality review and the latest stress tests, remains fragile. Moreover, the demand for credit remains suppressed in a moribund economic environment where growth prospects remain poor.
To maximise impact, the ECB should offer to buy whole portfolios of SME loans (and possibly other kinds of loans) off bank balance sheets at just below par and cut the interest rate on these loans substantially. Buying below par will mean that Spanish and Italian banks will sell but German banks will not. Lower interest rates will pass through directly to the most employment-intensive part of the real economy in crisis countries, short-circuiting a broken banking system. While this goes beyond conventional QE, it may be necessary in the euro zone’s bank dominated system. The ECB should also follow the Bank of Japan in buying Equities as well as Corporate Bonds.
While corporate bond purchases may be on the cards, the others are not.
It is most likely that the ECB will announce the purchase of investment grade assets, with sovereign bonds dominating the mix. EIB bonds may also be included. A special provision may be included for Greece provided it complies with conditionality.
Different countries have different amounts of sovereign debt outstanding and according to calculations made by Forbes, “under a hypothetical €500bn purchase programme, only 4.8% of Italy’s, 7.7% of Spain’s and 6.7% of the Eurozone’s sovereign debt market would be purchased. This compares to 21.5% in the US and 27.5% in the UK.” This holds if, as rumoured, the ECB follows allocates sovereign bond purchase quotas following its capital key. Under this assumption the ECB would buy Euro 88 bn of Italian bonds compared with the Euro 102 bn the ECB bought under the SMP. For Spain the respective figures are Euro 44 bn and Euro 63 bn.
The relatively small size of the programme compared to what was undertaken in the US and the UK also shows that the ECB may need to go much further than currently planned in order to have a significant impact on Eurozone inflation dynamics.
Private financial asset markets are much smaller in Europe than in the US. According to the WSJ “the European corporate-bond market is just 34% the size of the U.S. market as a proportion of gross domestic product, according to London-based think tank New Financial. The European leveraged loan and securitisation markets are 19% and 17% the size of their U.S. counterparts relative to GDP, and the venture-capital market just 15%.” This means that the ECB will need to concentrate its firepower in the sovereign markets. For example, according to the Economist while the size of the eligible and available covered bonds is € 1 trillion, the size of the sovereign bond market, at € 6 trillion is much larger. The ECB is also likely to announce the purchase of corporate bonds with as many as € 1.5 trillion of eligible corporate bonds outstanding.
However, given the relatively small size of other fixed income markets in the Eurozone and the unwillingness of the ECB to buy Equities, its intervention will focus on sovereign bond markets.
Even within sovereign bond markets the ECB will need to be politically expedient and make a trade off between effectiveness and flexibility. Purchases of longer dated bonds will be more effective in achieving its aims. It will also help if, as rumoured the ECB commits to holding these assets to maturity so investors can have greater predictability on how long the ECB will stay in the market. The risk that the ECB may choose to sell bonds it has just bought back into the market will reduce the effectiveness of such purchases,
Another dimension to this is the fact that the ECB would also not want to tie its hands in terms of how large its balance sheet is. The benchmark of buying bonds with a remaining maturity of three years or less that was set for the OMT is also relevant for this discussion particularly given how divided the ECB governing council is on the need for QE. It is likely that the ECB will concentrate on buying bonds with a remaining maturity of 5 years or less but will commit to hold them to maturity. For comparison the average maturity of the bonds the ECB bought under the SMP was 4-5 years. However, this is likely to distort the shape of the yield curve so the ECB is likely to also buy longer duration bonds, particularly ten year bonds though it would be surprising if it went beyond 10 years with a commitment to hold these to maturity.
The ECB will enact its QE program primarily by buying Eurozone sovereign bonds. It will continue to buy Asset Backed Securities as well as Covered Bonds under programs announced in late 2014, but may commit to increase the pace of purchase. Ideally, the ECB would focus on buying the sovereign bonds of countries such as Italy, which both has the largest amount of outstanding sovereign debt and is facing acute headwinds, but will most likely plump for buying sovereigns according to their share in the ECB capital key.
This means it may end up perversely buying more Bunds than any other bonds, despite the real yield on many Bunds already being negative. It is likely to concentrate its buying on bonds with a remaining maturity of 5 years or so (with some 10 years also purchased) in the secondary markets and disclose its intention to hold these bonds till maturity. It may likely also announce the purchase of some corporate bonds – perhaps between 10%-20% of all the purchases.
Do the modalities of these purchases matter?
Without doubt, the ECB’s program is politically controversial within the Eurozone. In particular, the Bundesbank is opposed to the programme, as is the German government. The German member of the ECB executive board is also opposed and the Dutch central bank has only offered conditional support.
The most likely compromise is for the programme to be structured differently from previous ECB asset purchase programmes, where the asset purchased have been on the balance sheet of the ECB. A good comparison is the difference between LTRO’s – the ECB’s Long Term Refinancing Operation and the ELA – Emergency Liquidity Arrangement.
Under the LTRO, any Eurozone bank could borrow from the ECB at concessional rates by pledging acceptable assets as collateral. In the event the bank defaulted and the collateral was not sufficient the losses would have been shared by the national central banks in proportion of their capital contribution to the ECB. In contrast, under the ELA arrangement, national central banks in crisis countries such as Greece, Cyprus and Ireland were able to borrow from respective National Central Banks conditional on the ECB not vetoing the decision. The main difference was that this was not on the balance asset of the ECB but on national balance sheets. The quality of collateral accepted was also in general poorer than what the ECB accepted under the LTRO. In the event of a loss, it would not have been shared across the Eurosystem but would have stayed on national balance sheets.
The head of the Dutch central bank has said that the QE program is acceptable to him, but only if the national central banks retain responsibility for their sovereign bond purchases – i.e. he does not like risk pooling on the purchase of bonds of crisis economies such as Spain and Italy. The Bundesbank is also less likely to be opposed to such an arrangement.
Most likely the ECB will deliver an in-between compromise on this risk sharing and the resultant QE may look like a hybrid between the risk sharing arrangements embodied in an LTRO and a ELA facility. Many are saying that this will signal the end of the Eurozone or that this will undermine confidence in the ECB as a pan-eurozone institution. There is something in what they say, but if one is to extend the analogy of the ELA program that was very useful in crisis management, there is not too much cause for concern. With the exception of Greece, no Eurozone country is close to default and the QE program will make default much less likely. Also, if the ELA analogy is to be considered in full, such NCB purchases might actually give more flexibility to the program particularly if National Central Banks can buy worse quality bonds.
As we discussed above, QE is likely to work through various channels and of these the NCB arrangement may somewhat undermine the confidence channel. But the increased flexibility, particularly if the credit worthiness of any country deteriorates further, may more than compensate for this. In any event, the ECB is likely to come up with a special arrangement for Greece and maybe Cyprus and no other country is in the danger zone for the issue of risk sharing to be a serious consideration. Moreover, the ECB QE will likely make the event of default for any Eurozone economy more remote.
Will the programme work?
In short, the programme will not, by itself, be able to deliver on the ECB’s inflation objectives. However, it will help exercise a positive pull both on inflation and on growth through the mechanisms discussed above. Much depends on global conditions, politics in the Eurozone and most important the fiscal policy that is pursued.
The biggest bang for the buck today in the Eurozone can come from a looser fiscal policy as well as more unified political stance. What is clear is that ECB QE is necessary, but it will be far from sufficient.
The ECB could increase the likelihood of success by increasing the size of the programme or firming up its commitment to an open-ended purchase until the inflation target is met. It can also improve the efficiency of the programme by selectively targeting assets in crisis economies as well as asset classes such as SME loans, corporate bonds and equities that have a more tangible and direct impact on the real economy.
In short, the ECB QE comes too late and will be too small in size and too narrow in scope to help meet the objective set for it. But that is a call for more action, not inaction.
Sony Kapoor is the Managing Director of Re-Define and a Senior Visiting Fellow at the London School of Economics