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01/22/2015

Towards a European Quantitative Easing

The European Central Bank (ECB) is planning to launch a program of Quantitative Easing (‘QE') in the first quarter of 2015. This European quantitative easing program is part of unconventional monetary policy: it is not based on a reduction of a rate (usually used in low-interest rate environment) but on the buyback of securities, mainly securitized loans and sovereign debt. Its medium to long-term goal is to inject liquidity in the financial system to move out of this particular period of steady inflation decline.

The announcement will certainly be made today in Frankfurt during the monetary policy committee. In December 2014, the president of the European Central Bank, Mario Draghi, announced the establishment of a bond purchase program in 2015 if the undertaken monetary measures had no effect on price stability.

The latest Consumer Price Index (CPI) released on 14 January confirms the continuous growth of prices and the drastic inflation decline (see Chart 1 below). In Q1 2015, inflation is expected to reach its lowest point since 2009 (see Chart 2 below).

Figure 1 : Monthly Consumer Price Index in France from 2008 to 2014

Figure 2 : Annual Inflation Rate in France from 2000 to 2014

Why is a "QE" necessary?

This sovereign "QE" complements a series of actions undertaken during 2014 which had no major impact on the inflation downward trend. The average inflation rate in 2015 was estimated at +0.5% below the ECB target of +2%. Inflation rate turned negative in December 2014. The ECB's main goal is to close the gap with its forecast in order to avoid a risk of deflation in the Eurozone. The three main actions underway are:

  • The decrease of the ECB Key Interest Rates from 10 basis points: the Main Refinancing Operations rate is at 0.05% and the Deposit Facility rate at -0.2% (which turned negative in June 2014) from 10 September 2014
  • The injection of liquidity via refinancing operations: liquidities were granted to banks via Longer-Term Refinancing Operations (LTRO) to increase lending to businesses and households. On 18 September 2014, the ECB conducted its first Targeted Longer-Term Refinancing Operations (TLTROs) with an allocation of €82.6bn. These refinancing activities have a 4-years maturity, one more year than the previous TLTROs in 2011 and 2012. A second LTRO took place in December 2014 with an allocation of €129.8bn. That operation was considered as a failure as the two previous operations allocated a mere €212.4bn, half of the €400bn initially proposed for the two operations.
  • The injection of liquidity trough covered bond buybacks (covered bonds) and asset-backed securities (ABS): on 9 January 2015, the three Covered Bond Purchase Programs (CBPP) were valued at €72.9bn while securitized loans buyback programs was estimated at €1.8bn

The ECB committed to bring the size of its balance sheet at its 2012 level of €3,000bn by June 2016. This represents €900bn more than the current €2,100bn. It is therefore important for the ECB to increase the pace of measures already undertaken and to launch other complementary monetary measures. According to Bloomberg, the debt buyback program may go beyond €500bn in asset purchase.

How does the 'QE' works?

To simplify, the ECB creates money by buying back bonds and generally non-performing assets (such as sovereign bonds and/or corporate bonds) of banks. As showed in Figure 1, the cash available to banks through the active buybacks should encourage banks to grant more loans to companies and households. Those loans would boost the real economy by increasing the purchasing power and the value of movable and immovable goods.

Figure 3: Simplified diagram of the injection of liquidity into the real economy through asset purchase programs

What are the subscription conditions?

The Governing Council of the European Central Bank must agree on the terms of "QE" likely to forge consensus and sustainably restore market confidence. Below are some topics that will arise in their decision:

Timing: A sovereign debt purchase program should not last too long. It would confirm the urgency of supporting a decadent economy and would only increase the fear of economic agents of the future, making the risk of deflation inevitable.

Eligible securities: The "QE" will address private securities (loans and corporate bonds) but will be mainly targeted at government bonds (sovereign bonds).

Participation: Sovereign debts from every country of the Euro Zone will be eligible. "QE" will eventually be subject to conditions depending on bond ratings: exclusive or partial "Investment Grade" or "Non-Investment Grade".

Creditor Status: For this operation, the ECB will have to abandon its senior creditor status and be treated as a pari passu creditor. In case of restructuring, majority creditors will be in center of all decisions. The ECB cannot risk interfering in the budgetary management of states in the event of failure.

Quantity: To avoid overwhelming the bond market, "QE" should address a limited quantity of securities. Sovereign debt demand denominated in Euro, Dollar, Yen and Sterling exploded in 2015. This is due to accommodative monetary policies and market expectations about potential sovereign "QE".

Distribution key: Sovereign bonds may be redeemed according to a distribution key defined by the weight of each state in the capital of the ECB. Germany, France, Italy and Spain would then be the main beneficiaries. (See Figure 4).

Figure 4: Distribution of the ECB's capital between the countries of the Eurozone (Source ECB)

Centralized or decentralized management: it is important that the purchase and management of the "QE" are performed by the ECB in Frankfurt and not decentralized among the National Central Banks. Decentralization at a national level would raise the issue of transferring responsibility of the monetary policy in the Eurozone.

Beside several technical details, many other issues may still arise. How will the credit risk be absorbed? Should we integrate the political risk associated with countries of Southeast Europe? What is the feedback from other central banks having used the "QE"? What are the main impacts on the banking sector? A second article to be published in February will try to answer these questions...

Sia Partners

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