The ECB bond-purchasing program

What's at stake: On May 10, 2010, the ECB announced that it would intervene directly in the euro area public and private debt securities markets in exchange for an explicit commitment to front-loaded fiscal adjustment by eurozone member states. The ECB Securities Market Programme (SMP) has since played an important role in stabilising Greek and Portuguese government debt markets. But past the announcement effect, other EMU countries which didn't enjoy direct ECB purchases have seen their spreads widening back to levels higher than before the ECB intervention. On Tuesday, the ECB will reveal in its Weekly Financial Statement its sovereign debt purchases for this past week.  Up until a week ago they had bought €40bn (reportedly all in Greece, Portugal and Ireland) out of a pool of €7,300bn eurozone sovereign debt. Disagreements within the ECB Governing Council have surfaced since the SMP was announced and give no clear indication as to how this important program is going to develop over the coming months, namely whether it should be broaden to cover other eurozone countries’ debts, turned into a real QE exercise or ended ASAP as it puts the ECB credibility and independence in jeopardy.

The rationale for the program

ECB President Jean Claude Trichet outlined in a speech his rationale for the program. Because the functioning of the market for government bonds is central to the transmission of the ECB’s policy rates, severe tensions in the bond market hamper the monetary policy transmission mechanism. Hence, Trichet argues, the need to act quickly to re-establish a more normal functioning of the monetary policy transmission mechanism.

Karl Whelan does not agree with Trichet’s characterisation of this program as one that is aimed at ensuring the reasonable functioning of the normal monetary transmission mechanism. The idea that spreads on certain instruments being higher than the central bank would like should prompt an intervention has not, until recently, been a standard monetary policy tool. And risk spreads being high is not usually seen as interfering with the “normal functioning of the monetary policy transmission mechanism.” What is true, however, is that when monetary policy rates are close to zero central banks can choose to provide extra stimulus by purchasing bonds to reduce spreads on the key instruments. This has been the essence of quantitative easing as practised by the Fed and the BoE. Trichet, of course, has been keen to point out that this is not QE because there are also some new operations to take in deposits from banks for a week, so this operation does not increase the stock of high powered money in the Euro area.

Short-term impact

Shaun Richards reviews the impact of the program on sovereign yields. One area where the policy has had some success is that it has helped reduce sovereign bond yields in the countries in question. For example Greek ten-year government bond yields closed at 7.71% overnight, Ireland at 4.81% and Portugal at 4.68%. These are lower than they were on the 10th May. One piece of bad news for the ECB on this front is the fact that Spanish ten-year bond yields are heading higher again and are now 4.26%. The initial effect of the May 10th rescue package for the euro zone had been to reduce Spanish ten-year bond yields back below 4%. So soon we may see purchases of Spanish government bonds and this is a more difficult problem for the ECB as she is a much larger economy and bond market than the ones intervened in so far. The clock might also begin to tick for Italy too as its ten-year government bond yields are now 4.14% after a long period below 4%. Calculated Risk has the picture for euro bond spreads.

QE or not QE?

FT Alphaville discusses the difference between the ECB’s bond purchases and those of the Bank of England: the ECB sterilises its interventions by reducing the liquidity in the money market. The idea is that the overall money supply remains unchanged. The article talks about “automatic” stabilisation, which essentially occurs through the deposit facility, where banks park their surplus liquidity over night. So the idea is that the ECB pays the banks for the bonds, and the money goes back into deposits, i.e. they are out of the money supply.

Guido Tabellini argues that there is no need to sterilise anything as the ECB continues to provide liquidity in unlimited amounts to banks participating in the weekly auctions. In other words, today the cash in circulation is determined by banks’ demand – it is not set by the ECB. The purchase of government bonds on the secondary market changes the composition of the budget of the ECB, but has no effect on its size, and therefore it does not alter the amount of money in circulation. So there is no need to sterilise anything.

Concerns

Guido Tabellini argues that the concern is not excess money creation (which is determined endogenously by the banking system), but rather the fear that the ECB will fill its budget with securities that will not be repaid in full. And sterilisation does nothing to address this concern. Ansgar Belke has a similar concern and argues that the sterilisation approach of the ECB is not well-suited to either diminish the bloated ECB balance sheet or to remove the potentially toxic covered or sovereign bonds. Mark Schieritz does the math and he’s not worried as a hypothetical 50% Greek haircut does not suggest a catastrophic impact on the ECB’s balance sheet.

Daniel Gros and Thomas Mayer argue that the ECB may have kissed credibility goodbye. With its move to prop up the failing bonds of governments in financial distress, it has allowed itself to be transformed into an agent of fiscal policy. The intention to sterilise bond purchases means, in effect, that it taxes euro-area private borrowers to support governments in difficulty. To the extent that it does not sterilise the effects of its intervention, it monetises government debt. To the extent that it does sterilise the purchases, it acts as a fiscal agent, taxing other euro-area borrowers to support a government in fiscal distress. The claim that intervention serves the purpose of creating orderly market conditions seems unconvincing when governments or the ECB decide which market movements are justified and which aren’t.

Free Exchange does not think the bond purchasing program spells death for the ECB’s credibility. That will ultimately rest on the course of inflation, and disinflationary forces now prevail in Europe. The ECB operations will arguably be helpful in offsetting those pressures. And if the rest of the package is successful, the ECB’s purchases will end up being minimal and costless. The ECB’s independence is, however, another matter as it has now become fiscal agent of last resort, which could ultimately weaken budget discipline among member states.

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