Saturday, February 21, 2015

The ECB’s QE: a mix of credit derivatives fostering the EZ disaggregation

Guest post by Marcello Minenna

The purchase programme of the ECB pushes towards the nationalisation of risks in the short-term, and in the long-term reduces the interests of the member States in keeping the Euro alive.

On the 22nd of January this year, the European Central Bank (ECB) launched a Quantitative Easing programme (QE) of more than 1 trillion bonds, which will be shared in a buying programme of 60 billion a month for a duration of 18 months. Ignoring for simplicity’s sake the fact that in the more than one trillion there are also private debt bonds, the QE will have an impact on inflation, but it will be reasonably heterogeneous in the Eurozone; in fact, it can be suspected that it will be more difficult for peripheral banking systems to transmit liquidity into the real economy. Overlooking the possible reactions of the other central banks, it is conceivable that the Euro will reach the value of the dollar, an equality which will, however, massively favour the big exporting economies. In any case, the weakness of the QE is the allocation of risks which could be neglected if the hypothesis of the ‘break-up of the Euro’ was sure to rule out relying on the anti-spread shield. The issue is that to activate the shield – if it were ever necessary – a political convergence on a full sharing of the risks at a European level would be needed, but there are no signs on the horizon.

To understand what the risks are to which we are referring, it is appropriate to take a step backwards to investigate why the purchase of government bonds has not been decided according to the best practice of the central banks of the world, namely without paying interests to the ECB and without discriminatory treatment on the risks of public debts of different member countries. Behind the tensions that led to this decision there is the German-made theory that a different intervention from the ECB would have created an undue mixture between monetary and fiscal policy and encouraged the moral hazard of the periphery. By not paying interest to the ECB, a member country could have, for example, reduced taxes or increased public spending, and thus have used the measure of the European monetary policy to national tax ends. Similarly, imagine the loss in value of the government bonds issued by a member country and bought by the ECB; such a loss concerning a national state would have been reversed on all Eurozone taxpayers. But the moral hazard theory is not supported by the facts.

On the issue of interests, some decisions made by the ECB certainly have fiscal policy implications but the terms are different. In the two-year period 2010-2012, with the Securities Market Programme (SMP), the ECB increased its budget of around €220 billion of bonds issued by Eurozone Peripheral Countries (EZPC). Considering the bonds expired in the last 24 months and the sterilisation performed on the secondary market, in December 2014 around €160 billion of government bonds – based on the decision of June 2014 – were not placed back on the market leading to an increase in the monetary base. What’s unusual about the SMP is that, unlike what happened with the buying programmes of the FED, Governments are required to pay interest to the ECB. In total, a flow of around ten billion Euros a year is estimated, which is then distributed pro rata in the Eurosystem (Germany 18%, France 14%, Italy 12% and so on). In other words, Germany through the Bundesbank receives nearly 4 billion of interests from the EZPC. So thus far, the monetary policy has induced fiscal transfers between member States, but from the periphery to the centre, not vice-versa.

On the issue of credit risk, i.e. the loss in value of a government bond, the solution of the buying programme decided on the 22nd January is that – with the aim of not creating undue mixtures – the ECB will directly purchase government bonds of the Eurozone for around 100 billion (8% of the QE), hence mutualising the associated risks, and it will provide liquidity to the central banks for 1 trillion to allow for the purchase of government bonds (80% of the QE) and of bonds issued by supranational European institutions (12% of the QE), including the ESM, i.e. the former sovereign bailout fund, which will likely have a relevant share.

The purchase of bonds will be based on the share of each Eurosystem country (see above).

At the end of the purchase, the national central banks will have the bonds as assets and in the liabilities a debt owed to the ECB for the same amount. This means that the national central banks are ensuring the ECB from risks of losses in value which could occur on that portion of the public debt of member States that will be interested in the programme. For example, imagine that the Bank of Italy buys 100 billion Euros of Italian government bonds. Then, if in the future Italy were to devalue the debt by 60%, in the assets of the Bank of Italy there would only be 40 billion Euros (or, equivalently, 100 billion Lira) and in the liabilities there would continue to be 100 billion worth of debt owed to the ECB. In practice, the mechanism with which the national central banks will lend the guarantee could also be different from the one suggested previously, but the basic reasoning does not change. In other words, by finishing in the assets of the national central banks, those government bonds become de facto subjected to foreign law, and as such, if the member country were to leave the Euro it could not reduce the value of the bonds by redenominating in the new national currency and then devaluing them, but it would be required to repay their full face value in Euros to the ECB.

From the financial point of view, the scheme adopted for the QE is therefore that of credit derivatives. In more explicit terms, the national central banks are selling a credit default swap to the ECB and they are cashing the premium. Obviously, it could be debated at length how a national central bank can issue guarantees on the public debt of its own state given the “connection” of the risks between the two entities.

Quantitative analysis based on the so-called “Italy risk”, applied to the amount of government bonds that the Bank of Italy should purchase through the programme, allows us to say that Italy should cash, for a similar insurance, more than 1 billion Euros a year until the maturity of the bonds purchased.

By taking on these risks, the national central banks will be remunerated through the interests on the government bonds purchased, therefore according to the same criteria of asymmetric distribution followed for the risks. The interests retained by the national central banks compensate for the guarantees given to the ECB for the risks of national public debt of the Eurozone included in the programme.

As for the purchase of bonds issued by European institutions (12% of the total), including an important role that will be taken on by the ESM, any loss in value will instead be borne by the member States according to their percentage of participation to the Fund (27% Germany, 20% France, 18% Italy and so on), given that the risks related to these bonds have been shared. In reality, at least for the bonds issued by the ESM, if one takes into account that for this Fund the risks have already been shared out by statute, the QE creates a sort of mutualisation to the square. Therefore, it is important to investigate the reasons for a similar decision. A possible explanation comes from the composition of the risks of the ESM that sees a significant amount occupied by the public debt of Greece. Its restructuring would determine losses in excess of the capital base of the ESM; therefore it seems that, in the doubt that in the future a member state may decide not to participate in the recapitalisation of the Fund, the QE will have pre-emptively resolved the problem by securely transferring the risks of such excess losses to the national central banks.

Also in this case the scheme follows the financial point of view of the credit derivatives. What’s the related premium? Well, taking the risk of Greece as a proxy for excess and neglecting the laughable returns of the ESM bonds, in the case of Italy – just to make an example – the premium associated with the purchase of bonds issued by the ESM would be around 1 billion Euros a year. This time however, without substantial compensations to the Bank of Italy for the insurance provided.

The argument can now be completed by referring to the 8% of the purchase of government bonds carried out directly by the ECB and whose risks are therefore shared at a European level. In this case, the credit derivative is sold by the ECB and bought by the member states of the Eurozone. By conducting quantitative analysis similar to those carried out so far we can see, for example, that in the case of the Italy the insurance for the 8% of “shared” risk on the Italian government bonds is worth around 100 million Euros a year.

The decision announced on the 22nd January is therefore not financially fair, nor are there “gifts” to “weak” countries of the periphery, and has little taste of United States of Europe. Rather, it is in line with the previous decisions, including that of mid-January which has set forth the possibility of relieving the Fiscal Compact in the presence of a recession not only in the Eurozone but also in the individual countries. This was also certainly a useful decision, but which does not address why the founding fathers of the Eurozone did not take into consideration the idea that the economic cycles of the member States could be misaligned. It will be random, but at this very moment the European regulators who deal with the risks in the balance sheets are saying that it is time to discriminate the government bonds of the different Eurozone members. For some time a metamorphosis of the European Union to the sum of the member States has been underway, and unfortunately the monetary policy did not intervene as it could have done.

- Paul De Grauwe, Yuemei Ji (2015), “Quantitative easing in the Eurozone: It's possible without fiscal transfers,, 15 January.
- Minenna, M (2014), “The European Public Debt Refinancing Program - Why the ECB Quantitative Easing Should Envisage Euro-Zone Government Bonds,” Rivista di Politica Economica forthcoming 
- Sinn, H W (2014), “Responsibility of States and Central Banks in the Euro Crisis”, CESifo, volume 15, no. 1
- Winkler, A, (2014), “The ECB as Lender of Last Resort. Banks versus Governments”, LSE Financial Markets Group, Special Paper Series, February.


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