Beauty or the Beast
The ECB's corporate bond purchase programme
On 10 March this year, the European Central Bank adopted one of its most extensive quantitative easing programmes ever. The move is a step into uncharted monetary policy territory and entails significant uncertainties and risks. Investors are rightly questioning whether the ECB's strategy makes sense.
1. The programme
Alongside interest-rate reductions for the main refinancing and deposit facilities, the programme also introduced new long-term liquidity measures for banks. It also boosted the securities purchase programme from EUR 60 billion to EUR 80 billion a month. Last but not least, the ECB announced that it would now buy corporate bonds in addition to government bonds. From June, six national central banks acting on behalf of the Eurosystem and coordinated by the ECB will purchase euro-denominated bonds issued by nonbank corporations totalling up to 70% of an issue, either on the capital markets or at the time of issue. An investment grade rating is sufficient for a bond to qualify for the purchase programme; only the issuer (but not the group or the parent company) must be established in the euro zone. The following article focuses mainly on the bond buying programme known as the CSPP.
The decision to expand the securities purchase programme was remarkable on several counts. Firstly, it was taken as the USA was starting to take steps in the opposite direction towards a tighter monetary policy. Europe's economy has started to gain momentum, with annualised real GDP growth within the euro zone topping 2% in the first three months of the year, significantly higher than the US economy (0.8%). European GDP growth significantly outstripped potential growth and that of preceding quarters. Although special factors such as the favourable weather clearly played a role, the question arises whether this was the right time for such drastic additional monetary easing.
Secondly, it was unusual for the ECB to include the purchase of corporate bonds in its monetary policy portfolio. Before the announcement, corporate bonds were a less significant element in the securities purchase programmes of central banks. As well as government bonds, the Japanese (who first started quantitative easing) also purchase asset backed securities, shares (in the form of ETFs) and commercial paper, but do not buy corporate bonds. In addition to government bonds, the Americans purchased mortgage backed securities of banks in particular. Only the British also purchased high-quality corporate bonds alongside government bonds. Given the lack of experience with the large-scale purchase of corporate bonds, the ECB is thus treading new territory.
Thirdly, it was notable that the ECB did not include bank bonds in its purchase programme – possibly because it had previously already purchased covered bonds from banks. Moreover, since banks can obtain significant liquidity through other channels, the ECB no longer deemed it necessary to purchase bank bonds. Banks are also benefiting from the new TLTRO. Some banks could of course gain additional scope for their lending business by selling bonds to the ECB to free up both capital and liquidity.
The ECB's announcement that it now plans to purchase corporate bonds has triggered a further contraction of credit risk spreads. Although banks now have significantly higher capital ratios than before (especially compared to the financial crisis), share prices of European banks fell by as much as 30% since the start of the year and the losses have only been partially recouped. In some cases, banks' refinancing costs have risen significantly (not least due to more stringent bail-in rules), sometimes considerably exceeding those of comparably rated industrial companies.
STOXX Europe 600 Banks Price Index (EUR)
Source: Bloomberg, internal calculation
This unsatisfactory development is primarily attributable to concerns about the profitability of banks, which in addition to exhibiting declining credit margins are also suffering from the ever-widening gap between the ECB's negative deposit rate and – continuing – positive customer deposit interest rates. Despite the ECB recently offering the banks some relief in terms of refinancing facilities, the unintended negative consequences are a cause for concern and raise question marks over the long-term success of the monetary policy measures. This is because under supervisory regulations, the expected income from ordinary banking operations forms the basis for banks' risk appetite. If income falls, banks must scale back their risk accordingly, thereby restricting lending.
The argument put forward by ECB Vice-President Vitor Constancio, that the decline in net interest income is more than offset by the reduced write-downs as a result of the economic recovery sparked by monetary policy, doesn't hold up to scrutiny. Loan defaults will also rise again over the course of the economic cycle, while the credit margins which should compensate for this risk will remain at the low levels at the time of the loans' origination. Moreover, as issuers will expect the ECB to purchase a significant number of their bonds even at the time of issuance, it is unlikely they will be prepared to continue paying high placement fees to the syndicate banks.
The main reason for including corporate bonds in the securities purchase programme was likely because the ECB feared bottlenecks in the government bonds market and wanted to prepare itself in good time. Indeed, it did not initially announce any upper limits for the purchase of corporate bonds.
3. Macro effects
According to reports, the ECB is planning "further monetary policy easing, aimed at facilitating a medium-term return to inflation rates of below but close to 2%". However, the ECB has not demonstrated a clear mechanism for achieving this target. Moreover, experiences with quantitative easing have been mixed. It has not proven to be the magic bullet allowing monetary policy to easily solve all problems, but at the same time there are no indications that it is totally ineffective or that it entails major negative effects.
Although Japan started quantitative easing as far back as 2001, it has not managed to break the vicious circle of slow growth and deflation. Quantitative easing has failed to produce significant economic growth, and hasn't sparked a return to inflation. The same also holds for the "Abenomics" strategy of recent years, under which the Bank of Japan significantly further bolstered its QE programme.
However, the ECB has not demonstrated a clear mechanism for achieving this target. Moreover, experiences with quantitative easing are mixed.
While many observers in the USA believe that quantitative easing has reduced the general interest rate level by around one percentage point, no major effects on GDP growth or employment are evident there, either. The securities purchases by the FED were certainly not the only factor behind the improving trends on the labour market in recent years. The same conclusion can be drawn, by argumentum a contrario, by the fact that the ending of the bond-buying programme in 2014 did not have more serious negative consequences for the economy.
As the euro zone has only relatively recently begun gathering experience in quantitative easing, caution should be exercised when trying to draw definitive conclusions. Since it is known that the effects of monetary measures take some time to materialise, the programme may simply need a little more time to take full effect. Currently, however, it is clearly not possible to claim that the bond-buying programme has had a lasting positive Impact. In March 2015, interest rates were already so low that they could not have sunk much lower. Although inflation remained low, this was largely attributable to falling oil prices. The economy only started to gain momentum in the first quarter of 2016. To what extent this can be attributed to the QE programme remains unclear, however.
Even the mere expectation of a large-scale purchase of corporate bonds by the ECB dangerously undermines the efficiency of the capital markets, ultimately resulting in false incentives.
Overall, it is likely that the macro effects of the extended bond purchase programme on the economy and inflation within the euro zone will also remain limited. On the other hand, the programme has significantly increased liquidity within the economy, triggering bubble effects in real estate and stock markets, for example. It has also had negative distribution effects, because interest rates on savings deposits fell (recently to zero), whereas other types of investments (which tend to be available to more affluent sections of the population) offered higher returns. This is of significance in a society where the issue of wealth distribution is an increasingly important topic of discussion. At the same time as claims concerning negative distribution effects of the ECB's policy are raised, the question of the bank's independence has also resurfaced. The ECB can no longer rely on its mandate alone. The recent discussion regarding the bank's independence was therefore not a coincidence and is gaining new significance ahead of the elections.
4. Effects on the financial markets
If other market participants are squeezed out by the ECB, there is a risk that the yield premiums for bonds which are eligible for the CSPP will not appropriately reflect the actual risk of default or make the necessary distinction between the relative fundamental performance of individual issuers. The very expectation of a large-scale purchase of corporate bonds by the ECB dangerously undermines the efficiency of the capital markets, ultimately resulting in false incentives. Investors will also likely find it more difficult to assert their justified interests as creditors against bond issuers if issuers can assume that the ECB will purchase their bonds simply so that they can call their purchase programme a success.
Protective clauses for investors (covenants) are thus becoming problematic at a time when they are needed more urgently than ever before. With regard to the bond market as a whole, it can be said that if demand for bonds increases because of the ECB, this will inevitably reduce interest rates, provided that demand from other market participants does not fall and that supply does not increase. Even just after the ECB's announcement, there was already a sharp increase in issuances by companies. The interest effect will therefore be limited. However, the spread between investment grade and high-yield bonds (which the ECB is not buying) may widen.
Yield differential between investment grade and high yield euro-denominated bonds
Source: Bank of America/Merrill Lynch indices, internal calculations
For banks, bond purchases by the ECB lead to a rebalancing of their balance sheets. There is a reduction in the item "securities", with the banks initially receiving cash. They could hold this money on deposit with the ECB, but would have to pay deposit interest. So in addition to losing interest income from the sold bonds, the banks would also incur additional costs, which could harm their role within the monetary transmission mechanism.
To avoid this, they can grant additional loans to companies and private individuals. This would be in line with the ECB's aims. However, they need equity capital and liquidity for this, and must also be able to bear the risks of lending. In practice, banks have often avoided additional lending, not least because of supervisory requirements. There also has to be sufficient demand from borrowers, which has not always been the case. In any event, loans to private individuals and companies within the euro zone have only risen very slightly recently (most recently at a rate of 1.1%), despite the low interest rates.
Alternatively, banks could invest the money abroad at higher interest rates (e.g. in the US). This would depreciate the euro. This was undoubtedly what the ECB secretly hoped for (but could not of course allude to). The euro has in fact only weakened slightly, and intermittently.
Another option is for the banks to use cash to purchase new bonds, possibly with higher interest rates or lower risks. The banks have two options in this context: They can do this in their own country, which wouldn't change much. Or they can do this in another country in the euro zone. For example, Italian banks have purchased large volumes of German bonds with the money raised from selling bonds to the ECB. This could be considered a type of capital flight and has led to a sharp increase (by almost EUR 100 billion since the introduction of the bond purchase programme) in the Bundesbank's target claims. This has considerably increased the Bundesbank's credit exposure.
When the ECB purchases corporate bonds, the procedure is generally the same as for government bonds. However, it is also important to consider that if interest rates for these bonds fall or if companies gain greater scope for issuing on the capital market, this will have additional direct positive effects for companies and could boost investment. In terms of cyclical effects, therefore, the ECB is not solely reliant on banks granting credit. To date, however, there has been very little such investment, as companies prefer to sit on high liquidity reserves, distributing higher dividends and buying back their shares. Moreover, the bond purchases only benefit larger companies (and not only those which belong to the euro zone) which have access to the capital market and which were already benefiting from lower borrowing costs anyway due to the sharp drop in interest rates.
The requirements placed on bond issuers (which include preparing bond prospectuses, reporting obligations and investor support) present an almost insurmountable hurdle even for larger medium-sized companies. In particular, the costs of awarding a rating and the associated rating process, which takes both time and a considerable amount of work, could deter many potential bond issuers. Small and medium-sized companies therefore remain on the sidelines and must hope to obtain more loans from the banks.
If the ECB purchases corporate bonds it naturally increases the risk of loan losses. The ECB's press release on the CSPP refers to "appropriate credit risk and due diligence procedures" prior to any bond purchase. According to current information, only an investment grade rating is required for the ECB to purchase bonds. Consequently, the bonds of Telecom Italia, for example, which are rated Ba1 with a negative outlook by Moody's and BB+ by S&P, and only BBB- by Fitch, are in principle eligible for purchase, even though the company's credit standing has been consistently deteriorating for some time and does not in our opinion warrant an investment grade rating.
Overall, the effects of the increase in the securities purchase programme and the expansion to include corporate bonds will likely be limited.
In addition, by relying on rating agency ratings as the qualification criterion for determining eligibility under the CSPP, the ECB is thwarting its previous efforts to counteract the dominance of rating agencies, whose central role in the credit markets has come under heavy criticism in the aftermath of the financial crisis. On the other hand, the ECB's securities purchase programme avoids the appearance of indirectly financing governments. This is currently an important point, especially in Germany. However, it is questionable whether the ECB has sufficient mastery of commercial banks' core business, i.e. corporate financing. This may prove problematic if credit defaults actually occur and losses are shared across the euro zone so that ultimately, it is the taxpayer who bears the costs. Whether there is any legal basis for this is more than doubtful and already the subject of complaints in Germany.
Overall, the increase in the securities purchase programme and the expansion to include corporate bonds will likely have only a limited effect on the financial markets. Market developments to date suggest that many investors share this view and are not overly convinced of any possible positive impacts. The initial euphoria in the stock market also seems to have quickly evaporated, and there are now concerns that further radical interventions in the capital markets could heighten volatility and even result in disappointment among investors. It is also important not to underestimate the detrimental effect the announced measures could have on diversified investment portfolios. If different asset classes react in similar ways to central bank interventions, the risk of losses increases and the quality of returns declines.
EURO STOXX 50 PRICE INDEX (EUR)
Source: Bloomberg, internal calculations
5. Evaluation of the programme, suggestions for improvement
Weighing up the positive and negative effects of the securities purchase programme gives a sobering result. The programme has not helped the economy or inflation to any great extent, but has led to distortions because of the market interventions and low interest rates. It is difficult to say which of the effects are the more significant. It is of course pointless to ask if things would be better if the programme had not been introduced. You can't turn back the clock.
The feeling that the ECB did much to overcome the financial crisis and mitigate the euro crisis in recent years is being replaced with the impression among many people that it's gone too far.
However, it's important to consider that boosting the programme in March had an effect which few people reckoned with. Some national economies (especially Germany) have become increasingly sceptical about monetary policy. The feeling that the ECB did much to overcome the financial crisis and mitigate the euro crisis in recent years is being replaced with the impression among many people that it's gone too far, and that less might be more. With regard to expectations, this has a negative effect on the effectiveness of monetary policy. It can also negatively affect the propensity to invest.
Unless any new negative effects emerge in the global economy which also affect the situation in the euro zone, the ECB should not take any new measures. They are not necessary and would not have positive effects.
Instead, the ECB should address the issue of what will happen in March next year when the current quantitative easing programme expires. This is now becoming an increasingly pressing matter. Three alternatives are conceivable:
- Continue with the programme as it is. This may not be wise if the economy continues on its current course and inflation increases, because the programme would then no longer be required.
- Bring the programme to a sudden end. This is also not advisable as it would shock the markets. Interest rates would rise. The euro would appreciate against other currencies.
- Let the programme end gradually, as in the USA. This is the best option from today's perspective. In such scenario, it would of course be necessary to decide which type of bond purchases to stop first (government bonds or corporate bonds), or to step down both gradually at the same speed. We believe there is a strong case for a simultaneous withdrawal, but this would depend on the volume of corporate bonds purchased up to then.
Any decision to end the programme gradually would require very sensitive and skilful communication. When the USA took such a decision (in May 2013), this led to a "taper tantrum" with significant negative consequences for the markets and the global economy. While Europe would not trigger global economic effects of the same magnitude, the effects on the markets would be considerable. The ECB must make it clear that in terms of the economy and the monetary union, it is best to end the programme gradually. If they do this correctly, they will meet with understanding.
 The CSPP (Corporate Sector Programme) is an expansion of the Asset Purchase Programme (APP).
 Based on the STOXX Europe 600 Banks Price Index (EUR)
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