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The ECB And The National Central Banks: Why It Doesn't Matter



  • The ECB is likely to announce a new set of measures on January 22nd. This involves purchases of sovereign bonds as well as potentially corporate and agency bonds.
  • The ECB's bond purchases will go through its national central banks. Whether loss is shared or not does not matter. What matters is size, scope and speed of the program.
  • The ECB's new program is likely to work like the Bank of Japan; less transparency with lager weight on buying 3-10yr maturity bonds to get long maturity bonds to 1%.

The European Central Bank yet again announces a program to ease financial conditions in the Euro area. Since the middle of 2013, the ECB has taken an incremental approach of introducing easing programs. It started with extended forward guidance to keep rates low for at least 2-years and then it followed with Targeted LTROs. Then it introduced its third covered bond purchase program (CBPP3) and just two months ago the ECB also announced ABS purchases. The incremental way is because the ECB is a "compromise driven" central bank. That means decisions are made on a majority rather than unanimity basis, and each new program has conditions attached. The incremental approach has made the ECB a central bank with the least amount of surprise announcements albeit there were exceptions to this rule (Draghi on 'whatever it takes' in July 2012 and hikes in June 2008 and Spring 2011).

For investors the ECB is perhaps the most boring and exciting central bank at the same time. That is because when the ECB (finally) announces QE on Thursday, the program has been fully "priced in". The market may quickly after that start speculating on European QE2, even that QE1 still has to be implemented. That is because of the incremental way new easing measures are announced. By definition that has put the ECB behind the curve to reach its 2% inflation objective. Just like in the US, UK and Japan, the first QE program was not sufficient and more is needed. A "foregone" conclusion is that 500 billion Euro of QE is not going to do the job and the ECB has to come back for more. One advantage the ECB has had versus other central banks, is that Mario Draghi is masterful at signaling. It is likely based on past experience, Draghi will signal on Thursday to keep the door open to more measures if warranted. The conditions to more future easing will remain the same however: 1) existing measures are insufficient and 2) the outlook for inflation worsens further.

What then to expect from ECB's QE1 and what does it mean for markets? The program size is expected to be 500 billion Euro with details to be announced after the meeting. Those details will most likely entail a large portion of the program in sovereign bonds of all Euro area countries, including program countries. There could also be a blend of agency, supra and corporate bonds be included. That blend is part of the compromise Draghi has reached with the German Bundesbank and Angela Merkel. The other part of that compromise is the execution of the program. This will most likely be done through the National Central Banks ("NCBs"). The contentious debate in the media is that how the risk is shared among NCBs. From recent reports in the German press, sovereign bond QE program appears to be likely conducted by the NCBs themselves. In other words each NCB buys its national debt probably mostly from its domestic banks. That would protect tax payers from cross border default risk (German tax payers are for example not on the hook for Italian or Greek government bond risk) and avoids subsidizing cross border banks that hold government bonds in large quantities.

A negative view about non-risk sharing is that if QE were to be implemented that way, monetary policy in Europe returns to the pre EMU days. During the time when the ECB was still a project titled "European Monetary Institute", the NCBs functioned in a 'coordinated fashion' to maintain their currencies within a band to the European Currency Unit (ECU). Although the NCBs set interest rates independently, they committed to maintain their exchange rates in band around parity to the ECU. ECU basket had specific weights by country that much resemble today's capital key ratios (determined by GDP and population weights). Through that system of exchange rate 'pegs' to the ECU, NCBs were de facto sharing losses. When an exchange of a country would fall out of its the band to the ECU, other NCBs would assist by providing currency to realign the currency in question. That would specifically be the case if the individual NCB could not control its currency through its short-term interest rates or by unilateral currency intervention. In today's Eurosystem, the NCBs are connected through the Target2 system. This system is an interbank payment system for the real-time processing of cross-border transfers throughout the European Union. Through this system NCBs are sharing gains and losses (and risk) in case of default or exit of one of the individual countries. It therefore doesn't really matter whether the ECB implements QE through NCBs individually or through loss sharing (capital key). Through Target2, the NCBs already share losses and risk.

The other views are about how NCBs would act as a creditor in case of a sovereign restructuring. In 2010 and 2011 the ECB conducted government bond purchases through its securities market program ("SMP"). In that program the ECB was a preferred creditor and senior to other creditors. When Greece restructured its debt in 2012, the ECB did not participate in private sector involvement (NYSEARCA:PSI) of the Greek bonds it bought under its SMP program. Investors reacted negatively because without the ECB participating, Greece's debt sustainability would remain in doubt (reportedly the ECB bought 16-18bn of Greek debt). When the PSI was finalized, the ECB received 100 back on a Greek bond that matured in March 2012. Other creditors that were owners of that bond received only 25 cents back. This set a precedent for future restructurings and as a result the ECB decided for "parri pasu" when it announced its open market transactions program ("OMT") in September 2012. There remains however a distinction: the securities bought under the SMP in 2010-2011 from Portugal, Spain, Italy, Greece and Ireland remain exempt from future PSI. These bonds reside on the different NCBs balance sheets under the SMP portfolio.

While the parri pasu status is important, if the ECB were to announce QE through its NCB independently, the parri pasu status may not make a difference in terms of loss sharing. That is because if a NCB purchases up to 20-25 percent of the outstanding domestic debt stock as was suggested by the Dutch NCB, in case of losses and the NCB's equity turns negative, the recapitalization of the NCB would still be passed onto creditors. The recapitalization of the NCB would not make it attractive for a government to restructure its debt as the cost of recapitalization may outweigh the benefit of restructuring.

There are a few other specifics of the European government bond market NCBs would have to deal with in a restructuring. In the fall of 2010 it was decided in Deauville that the European Stability Mechanism (ESM)--permanent bailout facility--would have a preferred creditor status on the loans and bonds it issued. In addition, every newly issue government bond would have collective action clauses attached (NASDAQ:CAC). So in case of a future restructuring the ESM would be senior to existing creditors and government bonds would be restructured by majority voting detailed in the CAC. The NCBs buying government bonds with CACs and ESM bonds would be a creditor that is junior to the ESM but parri passu to other creditors. Whichever way the ECB decides to start QE (risk or no risk sharing), it wont matter much to markets from a creditor standpoint. Markets have also so far not assigned a different risk premium bonds with CACs and those without, and neither to ESM bonds versus other comparable bonds.

The ECB's QE program is therefore the same kind of QE program as that of the Fed, Bank of England and Bank of Japan. In those programs it is assumed that default or restructuring is a low to zero probability. However central banks' role as a creditor in future restructurings remains also unclear because Treasuries, Gilts and JGBs do not have CACs. So the ECB is faced with the same status as a creditor and therefore markets will not make a differentiation in what kind of way the ECB/NCBs buy the securities. What matters is the program's size, scope and speed of implementation. Like the Fed, BoE and BoJ's programs, markets will quickly analyze how much duration risk is extracted from European government bond markets and how much is purchased as a percentage of net and gross issuance. Markets therefore care more about "flow" rather than the stock or creditor specifics. It is also not entirely unlikely that European bond markets may experience a temporary sell off just like Treasuries, Gilts and JGBs did when their QEs were announced. The implementation of the program will be about relative value and micro opportunities around auctions and syndicated issuance. That happened in the same way for Treasuries, Gilts and JGBs.

The most important question is how the ECB's QE program will transmit through other markets. Abundant evidence from the Fed, BoE and BoJ's programs is that the currency weakens vs. other currencies, stock markets rise, credit spreads narrow and volatility falls. That traditional QE transmission very much depends on what the market judges the future success of the program in terms of generating growth, stabilizing inflation expectations and improving employment. In that regard financial markets have so far responded almost identical in anticipating QE as they did when anticipating the Fed, BoE and BoJ QE. The ECB's program may have the most similarity with the BoJ. The objective is here too to get inflation closer to 2% through a weaker currency while driving long-term interest rates to 1% or lower to maintain debt sustainability in the wake of a structurally weaker Eurozone economy.