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.