QE, ‘European style’: Be bold but parsimonious

Urszula Szczerbowicz, Natacha Valla

09 April 2015

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Sovereign bonds are a natural target for the ECB’s Public Sector Purchase Programme (PSPP), the latest – and by far the biggest – of the Quantitative Easing (QE) policy conducted in the Eurozone. The pool of outstanding sovereign debt instruments is indeed the deepest and the most liquid, especially for highly rated bonds. Sovereign purchases are also expected to compress bond yields across the board (Carpenter et al. 2013), reduce interest rate risk along the yield curve (Greenwood and Vayanos 2015), and generate spillovers to other markets at similar maturities (Szczerbowicz 2014).

But shortcomings of sovereign purchases by the Eurozone have been subject to criticism even before their implementation. First, some have said ‘too little, too late’. Second, the geographic allocation of purchases, set to follow the share of each European Monetary Union member state in the ECB’s capital (the ‘capital key’), mechanically allocates almost half of all purchases to German and French bonds. Those markets already benefit from exceptionally low interest rates, and net secondary market supply is expected to fall short of planned purchases (both because current bond holders might stick to their portfolios, and because primary market issuance, in particular in Germany, will be small over the foreseen horizon of the Purchase Programme). Third, their market impact (flattening of yield curves) and macroeconomic effects (hiking inflation, spurring credit growth) are expected to be limited. Fourth, the Public Sector Programme might exacerbate tensions in the interbank market by extending the pool of outstanding sovereign debt trading at negative rates. That could in turn accessorily drain the already scarce collateral.

Twisting the programme to diversify the funding structure of the Eurozone economy

What if the Eurozone flipped its QE strategy around and selected assets based on their final economic use rather than on their issuer or on the asset class they belong to? In fact, a reasonable operational target for the ECB’s QE could be to facilitate the financing of growth-enhancing private sector activities, to stimulate investment, and to underpin European investment projects or joint initiatives, such as – but not only – the Juncker Plan.

The first way to implement a non-sovereign QE is to focus on private assets. These can be either issued by the financial sector or by non-financial corporations themselves. In fact, purchases of financial sector securities have been the ECB’s first asset purchase programmes. Way back in 2009, they started going quantitative by conducting outright purchases of covered bonds. They then followed suit in November 2014 with an ABS programme.

But this exclusive focus on securities issued by banks turned problematic. By doing so, the ECB did put all its eggs in the same basket, fully conditioning the transmission of its monetary policy on bank balance sheets. Looking forward, at a time when banks are engaged in a decade long process of balance sheet consolidation, the scope to kick start bank credit supply will remain constrained for a while (Bologna et al. 2014). But also, evidence suggests that there are many benefits in diversifying the sources of financing for firms so that they can find funding in all cyclical circumstances, in particular in early stages of upturns. Grjebine et al. (2014) show that economies with high share of bonds in corporate debt and high degree of substitutability of bonds for bank loans tend to perform better after economic downturns, i.e. they recover faster and more steeply (see Figure 1). Supporting the diversification of financing sources seems like a reasonable objective for the ECB as it provides the ECB with alternative channels for monetary policy transmission (Coeuré 2015, Mersch 2015).

Figure 1. Economies with high share of bonds in corporate debt perform better in recoveries

Source: CEPII, Grjebine et al. (2014).

Financial instruments issued directly by the corporate sector would therefore be a premium candidate for QE. By purchasing them, the ECB would foster the development of those markets and most surely improve and speed-up the nascent recovery of the Eurozone economy. En passant, that would also be a plus to move the Eurozone towards a Capital Markets Union (CMU), as foreseen by the European Commission (EC 2015).

What size of corporate bond purchases could the ECB aim for? Corporate bonds are already accepted as collateral in the ECB open market operations (OMOs). In fact, according to the most recent published numbers, the ECB identifies an outstanding amount of €1 393 billion of such assets eligible to its OMOs, of which only a mere €74 billion have actually been pledged! This leaves a substantial outstanding stock that could be bought outright by the ECB without running the risk of creating a collateral squeeze. In the recent past, corporate bonds were bought by the Bank of England and the Bank of Japan to facilitate corporate refinancing and investment. The Fed also purchased unsecured corporate commercial paper and asset-backed commercial paper. So, that would not be such an exotic endeavour after all.

But we should keep in mind that by buying corporate bonds, the ECB would directly interfere in the development of bond markets in Europe – again a matter to be looked at, and perhaps levered within the Capital Markets initiative. This can be constructive if done carefully. First, the development of European bond markets must go along with appropriate regulation. Second, the impact of ECB massive interventions on market liquidity should also be anticipated and fine-tuned. The BIS and others have recently pointed to bond market liquidity as a cause of concern (Fender and Lewrick 2015). This issue should be considered seriously, bearing in mind that the ECB purchases might also stimulate bond issuance by firms that would otherwise not be active in those markets.

Purchases of agencies and international European institutions: Be massive, but parsimonious

A more direct financing of the real economy could take yet another form. In fact, the ECB’s QE programme already explicitly includes securities of European institutions that finance European investment projects, such as the European Investment Bank (EIB). Not only would these purchases support the Eurozone deficient demand in a way that is geared towards long-term growth objectives, but they would also deepen European integration. At the current juncture, this is no luxury as low investment and weak growth is a source of concern in Europe (Giovannini et al. 2015). The total available euro-denominated pool of bonds issued by the EIB is of around €200 billion. As the ECB programme currently stands, the purchases of such securities are subject to loss sharing and limited to 12% of the programme. It seems that substantially increasing this limit beyond 12% would make QE more efficient (see Figure 2).

Figure 2. The universe of purchasable agencies and European Institutions should not be underestimated

Source: RBS, ECB.

Purchases of ‘agencies’ and ‘European institutions’

In its Public Sector Purchase Programme, the ECB distinguishes between ‘agencies’ and ‘European institutions’. This has gone unnoticed, but might in fact be key. While the ECB purchases of European institutions securities are constrained by 12% ceiling, the purchases from agencies are not subject to the same limit. When publishing the nitty-gritties of its programme, the ECB even indicated that national central banks could choose between sovereign or agencies, and that if they were not in a position to execute the planned monthly purchases of sovereign or agencies debt instruments (for example, because there would be none to sell in the market), they would have the possibility to buy European institutions instead. This means that the ECB would be in a position to massively support public investment simply by buying bonds from national promotional banks such as the German Kreditanstalt für Wiederaufbau (KFW) or Spain’s Instituto de Credito Oficial (ICO), or from the EIB, or even instruments issued under the heading of the Juncker Plan, instead of their sovereign counterparts.

Yet, while we fully support ECB’s purchases of agencies (and in fact we believe that they should be the backbone of QE), parsimony in the choice of agencies will be critical. Indeed, the list of eligible agencies as published by the ECB covers a range of very different animals. For instance, the list includes CADES (a body created to bear the debt of the French social security system) and UNEDIC (body in charge of France’s unemployment insurance, which is largely in deficit). These bodies have little to do with investment and long-term growth, and it is not clear that European public opinions will be that pleased when they find that out. When selecting its eligible agencies, the ECB might be well advised to select them not only on the credit worthiness grounds but also according to their economic purpose.

References

Bologna, P, M Caccavaio, A Miglietta (2014) “EU bank deleveraging”, VoxEU.org, 14 October

Carpenter, S, S Demiralp, J Ihrig and E Klee (2013), “Analyzing Federal Reserve Asset Purchases: From whom does the Fed buy?”, Federal Reserve Board Finance and Economics Discussion Series 2013-32.

Cœuré B (2015), “What is the goal of the Capital Markets Union?”, Speech at a conference "The European Capital Markets Union, a viable concept and a real goal?", 18 March 2015.

European Commission (2015), “Building a Capital Markets Union”, Green Paper, 18 February 2015.

Fender, I and U Lewrick (2015), “Shifting tides - market liquidity and market-making in fixed income instruments”, BIS Quarterly Review, March 2015.

Giovannini, A, C Mayer, S Micossi, C Di Noia, M Onado, M Pagano, and A Polo (2015), Restarting European Long-Term Investment Finance: A Green Paper Discussion Document, 30 January. 

Greenwood, R and D Vayanos (2015), "Bond supply and excess bond returns", Review of Financial Studies, forthcoming.

Grjebine, T, U Szczerbowicz and F Tripier (2014), “Corporate Debt Structure and Economic Recoveries”, CEPII Working Paper, Nr 2014-19 November.

Mersch, Y (2014), “Capital markets union – the ‘Why’ and the ‘How’”, speech at Joint EIB-IMF High Level Workshop, Brussels, 22 October.

Szczerbowicz, U, (2014), "The ECB's Unconventional Monetary Policies: Have they lowered market borrowing costs for banks and governments?", RIETI Discussion paper 14008.

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Topics:  EU policies Financial markets

Tags:  quantitative easing, eurozone, sovereign debt, corporate bonds purchase

Economist, CEPII

Deputy Director, CEPII

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