How Many Irish bonds can QE buy?

The ECB’s expanded  QE is due to start in March and a figure of €12bn is often reported in terms of the amount of Irish sovereign debt that the Central bank can buy. The case is not that clear-cut , however,  and the limit may be only €9bn from June.

Bonds purchased in any EA  country  under QE are subject to a number of restrictions. The first limits the share  of the total each country can buy. In Ireland that means about 1.7% of  the €60bn per month  QE target, which includes private and  EU supranationals as well as government debt. The second limits central bank buying to 25% of any issue. A third puts a  33% ceiling  on the amount of   any issuer’s debt that can be held . The latter only makes sense relative to the 25% limit if existing central bank holdings are included .

Indeed,the ECB does already own some sovereign debt, purchased under the Securities Market Program (SMP) , which stands at €144bn having fallen from over €200bn (via bonds maturing). We do not know the  current breakdown of that holding by country but the ECB did publish that data as at end-2012. At  that time €14bn of Irish government debt  had been purchased, 6.5% of the then total, which implies about €9bn today, assuming redemptions were broadly proportional over the past two years.

The Irish Central Bank also owns government debt stemming from the Anglo Promissory note. Part of that was repaid  in 2012 via the issuance of €3.5bn  of the 5.4% 2025 bond. The Bank announced it had sold a portion of that in 2013 but presumably still owns around €3bn of that issue. In addition, the Central bank received €25bn in long term bonds as part of the Promissory note deal in 2013   and again has sold a small amount, leaving €24.5bn.

Another QE stipulation is that  only bonds with a maturity  between 2 and 30 years are eligible, which in Ireland’s  case gives a current figure of €86bn. That implies  €8.5bn of central bank holdings are within that range ( including €5.5bn of the Prom note bonds) which alongside the €9bn SMP figure gives €17.5bn or 20% of the total at issue. The issue limit therefore leaves only 13% open to further purchase, which is just under €11bn

Finance Minister Noonan stated that the Central bank had ‘ample room ‘ to purchase Irish debt. However, the situation changes in mid-year as  €3bn of the Prom note bonds redeem in June 2045 (i.e. would then fall within the 30 year limit), so  from then on the CB’s eligible  holdings rise to €20.5bn or 23% of the total, implying less than €9bn could be added.

Some SMP holdings will mature over the next 18 months and the Central bank will sell some of its Prom note bonds, so giving some room for additional QE, The NTMA will also issue new debt (perhaps another €11bn this year) which  will qualify as long as it is over 2 years so raising the remaining limit for the Central bank rule. Perhaps not quite as ‘ample’ then as some think, in the short term and with more moving parts.

 

ECB to buy Government debt but limited risk sharing

The ECB today decided to buy sovereign debt, a decision  which, although widely anticipated, had the immediate effect of weakening the euro further on the FX markets and  giving a further fillip to government bonds, which were already at record yield lows in many cases. Equities too rallied although it remains to be seen  when the dust settles how much of the ECB policy change  was already priced in to markets.

Mario Draghi gave two reasons for the move. First, inflation has been weaker than expected and inflation expectations have fallen further, which could in turn have a negative impact on wage and price developments particularly given the level of spare capacity in the euro zone.Second, the existing monetary policy measures in place have not had much of an impact and in that context it was announced that the interest rate on the long term loans available to banks (the TLTRO) will be reduced from 0.15% to 0.05% , an implicit admission that the take-up has been disappointing.

The ECB is also currently buying private sector debt (covered bonds and asset backed securities) in the secondary market  but again the impact has been limited, with only €35bn purchased to date. Consequently the ECB decided to significantly expand the programme to include public sector debt (Government and European Institutions), although some in the council were still of a mind to wait and see how inflation develops in the coming months. The expanded QE programme will now amount to €60bn per month, starting in March and continuing until September 2016,with the prospect of extending it further until there is a ‘a sustained adjustment in the path of inflation which is consistent with our aim of achieving inflation rates below, but close to, 2% over the medium term’. The minimum purchased will therefore be €1,080bn and the final figure may be well above that .

One area of market debate ahead of the decision was the issue of risk sharing-  the ECB had shared the risk of the Securities Market Programme ( a previous and limited excursion into the sovereign debt market)  but there was some opposition to this in terms of QE, notably from Germany. In the event 12% of the purchases will be European institutional debt and all the risk of that will be shared, with the ECB also purchasing another 8% of debt on its own books. Consequently 80% of bonds purchased will be at the risk  of national central banks, implying over 90% of bonds excluding the European institutional debt.

Another question was which sovereign  bonds to buy and the ECB decided to allocate purchases by using the capital key ( each national bank’s contribution to the ECB’s capital). Euro countries provide only 70%  of the later so one assumes that the share will be adjusted pro rata for the euro members.  This would give Germany a figure of 25.6%, France 20.2%, Italy 17.5% and Ireland 1.7%.Clearly, then, purchases of German, French and Italian debt will dominate. If one assumes that €50bn of the monthly purchase is sovereign debt (the rest private sector and European Institutions) the figure for Ireland would be €0.8bn against over €12bn for Germany. The respective debt markets are very different in size though so it is more meaningful to estimate how much of the market would be owned by central banks after 18 months and that gives some interesting results; the central bank would hold 19% of Portugal’s debt, over 14% in Germany, some 13% in Ireland but less than 9% in Italy.  Indeed, in some of the smaller EA  countries with little debt the scheme would imply less than half the debt left in private hands,  and so the ECB announced certain limits, including 30% of the issuer as a maximum.

What  impact will it have on the real economy? When asked, Draghi put forward three  effects. The scheme  is a very significant move for the ECB and hence may boost inflation expectations. Second it will lower funding costs further and hence  may stimulate credit growth and spending. Third it will strengthen the ECB’s forward guidance on interest rates. He did not add it has already resulted in a currency depreciation. Will it work? QE in the UK and the US certainly seemed to boost equity markets and growth did pick up, although core inflation in both economies is still below respective central bank inflation targets. Draghi himself does not seem too hopeful – he responded  to a question about the risks of hyper-inflation when central banks print money by pointing out that  that inflation has not taken off elsewhere in the wake of QE. This begs the obvious question as to its usefulness as a tool in generating inflation in the EA, such is the weakness of domestic demand, but the ECB is clearly desperate to try everything in an envoronmnet when an alternative, expanding fiscal  policy, is deemed verboten.

Falling Prices versus Deflation

Consumer prices in Ireland fell by 0.3% in the year to December, providing a welcome boost to the real income of Irish households. Prices also fell across the euro area, declining by an average 0.2%  Good news then, one might think, so consumers may well be puzzled by the reaction of policy makers, with the ECB announcing its intention to take further action in order to raise prices and boost the  euro  inflation rate  towards 2% per annum, citing the risk of deflation as the catalyst for the move. Why are falling prices deemed a bad thing when central banks have spent most of the last fifty years worrying about the problems caused by rising prices?

Not everyone is convinced that deflation currently exists in Europe because the concept involves the notion of a persistent fall in prices rather than a short term period of negative inflation. This in turn depends on what is causing prices to fall – is it in response to a supply shock such as a rise in oil production (which some economists have termed ‘good deflation’) or as a consequence of falling demand (‘bad deflation’.) Looking at the Irish CPI it is clear that a key factor is the sharp decline in global commodity  prices , which started in earnest over the summer months and has resulted in declining food prices ( down 2.7% in the year to December) and energy costs ( down 5.5%). The latter has further to fall and largely for that reason most forecasts  envisage the annual inflation rate staying negative in Ireland and across the euro area for at least the first half of 2015.

If one excludes energy and unprocessed food Irish prices rose, albeit by a modest 0.5%, and this points to the case  against the prospect of deflation – energy prices will not fall for ever and so the deflationary impact on the CPI will eventually fade. Goods prices account for less than  half of the Irish CPI (45%) and the price of services is still rising ( up 1.7% or 2.8% excluding mortgages) so a sustained fall in  the CPI would probably in turn require a prolonged and heavy  fall in wages. Ireland has seen a  modest fall in wages on one measure (the micro data at industry level) but not on another (the aggregate wage figure used in the national accounts)  while wage growth is positive on average across the euro area.

The performance of  euro equity markets would also suggest that deflation is not a base case,  and the ECB concurs, although stressing that the risks have risen. Modern experience of deflation is limited to Japan but prices also fell steadily during the Great Depression in the US and elsewhere, which has contributed to the association of falling prices with very negative developments in the real economy. The argument partly focuses on expectations , with households and firms postponing consumption and investment in anticipation of lower prices  next year. Deflation will also  affect real interest rates as nominal rates for most borrowers are bounded at or close to zero, implying real rates will rise if the price level falls. This would increase savings and reduce consumption and investment.Similarly, if nominal prices and incomes fall the real burden of household and government debt rises, a particular concern given the current scale of outstanding debt.

The expectations element in deflation has made central banks, including the ECB, very keen to monitor the private sector’s view on future prices. That can be hard to gauge (surveys tend to be strongly influenced by the recent trend) which makes market-based measures ( inflation swaps or derived from nominal versus real bond  yields)  popular as they can be monitored in real time. On that basis the US market is expecting inflation  to average around 1.5% a year for rhe next decade while the ECB’s favourite measure suggests euro investors expect inflation in 5-years time to also average around 1.5% over the following 5 years.

Evidence, then, that inflation is expected to be low and certainly below  the 2% level many central banks view as optimal, but not that there is a widespread belief that inflation will stay negative for a long time. This low inflation outlook is not a scenario which implies strong growth in nominal wages but certainly one in which short periods of falling prices is a positive rather than a negative.

 

The 2014 Budget outturn was very different to that envisaged when delivered

Ireland’s Budget for the following calendar year is now presented in early October, which increases the probability of forecast errors. Such errors are a feature of any fiscal projections but are notable in the Irish context; the median difference between the  forecast Exchequer balance and the outturn over the past fifteen years is €2.5bn. This is not to put any blame on the Department of Finance or to suggest any inherent bias ( the  sample is evenly split between overshoots and undershoots relative to target), but rather to highlight that errors are highly likely in an economy as volatile and open as that of Ireland, and that unexpected events can and often do materialize.

Take the 2014 budget. The fiscal projections were predicated on real economic growth of 2% , including a pick up in consumer spending and a very modest contribution from the external sector, with exports forecast to grow by 1.9%. It now seems likely that the economy grew by 5% last year , with exports growing at a double digit pace. Moreover, consumer spending growth was probably less than 1% while inflation has been much lower than forecast, although the labour market has been much firmer, with the unemployment rate averaging around 11.5% against the projected 12.4%.

The Budget arithmetic had anyway changed by the beginning of the calendar year, with debt service costs  then seen to be €400mn lower than initially envisaged and revenue boosted by  the full amount of receipts from the sale of the national lottery (instead of half).As a result of these factors and other changes the projected 2014  Exchequer deficit was revised down in April to €8.7bn from the original Budget target of €9.6bn

It also became clear early in the year that tax receipts were running ahead of profile and that trend continued over the course of 2014, with a final outturn €1.2bn above target; tax revenue grew by 9.2% instead of the envisaged 6%. All tax headings came in above expectations with the exception of the Local Property Tax , including a  €400mn overshoot in VAT, €234mn from Corporation tax and  in excess of €200mn from Stamp duty, including monies from the pension levy.

That tax oveshoot would have resulted in a deficit below €7.5bn, all else equal, but in the event  the Government chose to use some of the largesse to increase spending. That decision was taken relatively late in the year as expenditure has been on or below target for much of 2014, but  at end- December  emerged €840mn or 2% above profile. Most of this additional outlay went on Health, which begs the question as to the realism of the original target spend for that Department.

As a consequence the Exchequer deficit for 2014 emerged at €8.2bn, above what might have been achieved but well below the original target of €9.6bn and  the lowest deficit since 2007. The NTMA funded the shortfall by borrowing a broadly similar amount and used existing cash balances (i.e. previous overfunding) to repay €8.2bn to the IMF.

So one might say it turned out all right in the end but somewhat different from that envisaged when the Budget was originally delivered, an all too common experience for the Irish exchequer and one which implies it would be fruitless for Ireland to try and fine-tune economic growth via fiscal policy, even if that were possible given euro rules. On final point: the Government is now using the Irish semi-state companies (particularly the utilities) in a more aggressive way to raise revenue, with dividends  received amounting to €475mn in 2014, against €264mn in 2013 and €112mn in 2012. The ESB alone ( and therefore its customers) have  has contributed €840mn since 2008.