The ECB implements full-fledged quantitative easing (QE) next week, and many hope nearly €1 trillion of sovereign bond-buying will rocket the eurozone out of its supposed post-recession malaise. As we wrote here, those hopes are probably too lofty, because QE isn’t stimulus—it flattens yield curves, defying over a century’s worth of economic theory and data showing steeper curves are best, and eurozone yield curves are already crazy flat. But here’s another wrinkle: It is far from certain whether the ECB can even reach its monthly bond-buying target. The ECB’s own capital requirements and interest rate policy might shoot its plans in the foot—not an economic negative, necessarily, but evidence policy there is rather wacky.
The ECB plans to buy €60 billion in bonds monthly—€13 billion in asset-backed securities and covered bonds, and €47 billion in sovereign debt. That €47 billion will be split between 18 of 19 eurozone member-states[i], dished out according to each country’s portion of the bloc’s population and GDP. People who have done all the math say German bunds will account for nearly 25% of the program, with France, Spain and Italy close behind.
Two Wall Street Journal articles published Wednesday highlighted some of the obstacles the ECB faces. One, “ECB Faces Struggle in Sourcing Enough Bonds for QE,” shows how supply is limited:
The German treasury says it expects to issue this year €147 billion of eligible bonds—those with maturities of two to 30 years—while €132 billion of bonds will mature, meaning net new bund issuance of just €15 billion for the whole year. Overall, the ECB’s plans mean it has to buy €215 billion of German government bonds between this March and September 2016—26 times more than the amount the German government bond market is predicted to grow over the same period, Morgan Stanley says.
It goes on to note that banks, pension funds and asset managers own most of the existing supply, and they might not be keen to sell. Many pension funds have strict mandates to own a certain portion of government bonds. Ditto for institutional investors. Banks, meanwhile, probably won’t be keen to swap higher-yielding government bonds and forfeit that stable return when there is no suitable replacement on the open market—not with yields now below zero in most cases and potential loan profits so slim (thanks to those flat yield curves, which represent banks’ net interest margins).
The other piece, “Europe’s Banks at Risk of Japanese Fate,” adds two other technical difficulties:[ii]
But there are two problems. The banks need government bonds to help meet new liquidity rules that ensure high-quality assets can cover a sudden loss of funding.
Also, banks make good profits on these bonds. Most banks in Europe get to treat them as risk free, so they attract no capital charge. Near costless long-term funding from the ECB has allowed banks to take most of the yield on government bonds as straight profit.
For Greek, Spanish or Italian banks, where local yields are higher, that is very attractive. As ECB board member Peter Praet said this month: “Risk adjusted returns for banks on loans have been very subdued relative to returns on... domestic government bonds.”
Look, banks are for-profit.[iii] Eurozone banks will only sell their profitable sovereign debt holdings if they can do something even more profitable with the proceeds. Which brings me to the elephant in the room here. When central banks do QE, they don’t buy bonds for cold, hard cash. Contrary to widespread belief, they are not actually printing money. They are instead creating electronic central bank reserve credits—waving their magic wand over banks’ deposit accounts and making those deposits bigger. In fractional reserve banking systems like the US, UK and eurozone, banks are supposed to lend off these reserves many times over. In the US and UK, they didn’t, because yield curves were too flat, shrinking loan profitability to the point lending just wasn’t worth the added risk. So banks just pocketed the small interest payment on their excess central bank reserves—those new reserve credits—and called it a day. In the eurozone, however, the ECB has set a negative deposit rate. Instead of earning 0.25% like US banks or 0.5% like UK banks, eurozone banks basically have to pay a -0.2% fee on their excess reserves. Why would a bank swap a bond yielding a couple percent in exchange for something that charges a fee? Especially when flat yield curves make it near-impossible to transform those credits into profitable new loans?
Now maybe the ECB finds a way around all this, like by buying bonds at a nice premium.[iv] Time will tell. But the existence of this quandary suggests eurozone interest rates, regulatory requirements and long-term goals are misaligned. The eurozone economy can probably keep going, as it has already proven its resilience in the face of these and other structural headwinds, and again, the region needs QE like it needs a hole in the head. But it does show how having too many competing policies, no matter how well-intentioned, can create a big yarnball of counterproductive weirdness.[v]
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[i] The ECB decided in January it had quite enough Greek bonds, thank you very much.
[ii] It goes from there to a weird place, drawing comparisons with Japan’s so-called zombie banks from the 1990s, arguing eurozone banks have too many nonperforming loans to be able to lend more now, then suggesting the ECB slap capital surcharges on banks’ sovereign bond holdings to nudge them into selling. That’s all sort of bizarre. The parallel with Japan is false, and eurozone banks don’t own sovereign bonds to make up for lost income on nonperforming loans. They do it because they have to park their money somewhere, and there is a dearth of profitable alternatives.
[iii] These days, it’s fashionable to say for-profit banks are icky, and they should behave more like do-gooder non-profits, treating lending as a public service. Um, folks, Spain tried this, with its small, non-profit regional lenders known as cajas. They all blew up when Spain’s housing bubble burst—turns out, when you’re a non-profit, you don’t have much incentive to make judicious loan decisions, because you don’t care so much about whether you get paid back. Spanish officials figured this out and decided the solution was merging these institutions into for-profit megabanks, and that’s working out fairly well.
[iv] Though I imagine this would inspire some wacky “Audit the ECB” bill in the European Parliament.
[v] This is a technical term.