This week has seen the European Central Bank (ECB) start its gigantic bond-buying program. It hopes this cash injection will shift the euro-area economy into a higher gear. But will the program really achieve its ambitious objectives? And what side-effects can we expect to quickly emerge?
The ECB is aiming to buy in 60 billion euro worth of bonds in total every month, more than 40 billion euro in the form of eurozone sovereign bonds. The breakdown of this buying activity between countries will approximate to the established capital key, i.e. the formula by which the individual euro states subscribe to the ECB's equity. On this basis, German Bunds will make up approximately 25 percent of the planned government bond purchases.
The ECB also appears to be prepared to pay a high price for its bonds. ECB chief Mario Draghi announced at the most recent press conference that bonds yielding above the deposit rate will be bought. This currently stands at -0.20 percent. This means the ECB will accept paper with yields as low as -0.20 percent.
It is unusual for a buyer to state both its target quantity and maximum price in advance. There is now no reason why potential sellers should sell the ECB the bonds it wishes to buy below this ceiling price. This is true at least for those markets whose available volume is small in relation to the additional demand that is now being generated. The ECB's pricing must therefore be designed to quickly maximize the volume of additional liquidity.
We can demonstrate this using the example of German Bunds. On the current planning, Germany will not take on any new (additional) debt in 2015. This implies that this year's total Bund issuance will be only" 140 billion euro. However, the ECB alone is committed to buying in 160 billion euro worth of Bunds. Remember that at the same time, German banks will also be obliged to increase their regulator-imposed liquidity reserves by around 20 billion euro. And they are only allowed to use highly liquid and readily marketable paper, essentially Bunds. This suggests structural demand for Bunds of roughly 180 billion euro in 2015. The fresh supply of Bunds will fall far short of this total.
For this demand to be met, holders of Bunds would need to be willing to divest part of their holdings. The big Bund investors are banks, insurers and central banks. None of these investor groups has any incentive to sell their previously acquired Bunds at this point in time. Both banks and insurers need these bonds and their comparatively high yields to sustain their business models and to be able to satisfy regulatory requirements. Selling bonds from their stock would mean forfeiting future income. They could only make good the resulting deficit by taking on higher risks elsewhere, a development that both the insurers' customers and the banks' regulators would presumably view unfavorably.
What will follow from this? Bund prices across the maturity spectrum will very quickly head up towards the ECB's stated maximum -- without any regard at all to the evolution of the fundamental framework conditions that shape the German and euro yield curves in normal times. Bund yields will probably go negative through to ten years out in no time at all. As a result, the yields of the other euro countries' bonds should also fall perceptibly and their spreads to Bunds narrow even further -- and once again this process will occur in total isolation from the fundamental trend of individual economies.
But the ECB would then have achieved its goal. The newly prevailing high bond prices would strongly boost eurozone liquidity. Although this liquidity would be located primarily in the banking sector, the hope is that the relentlessly increasing pressure to generate returns -- which the ECB will also help to stoke in its role as regulator -- will induce the banks to extend more credit and thereby make their own business growth either more sustainable or sustainable in the first place. When stronger lending activity accelerates the real economic cycle, inflation should rise and inflation expectations firm again. And that, on the ECB's interpretation of its price stability mandate, is after all the purpose of the exercise.
So what are the foreseeable ancillary effects? Traditional investors get forced out of the government bonds market and into riskier asset classes. In addition, market mechanisms are rendered largely ineffective since the market prices of bonds no longer adequately reflect their inherent risk, i.e. they are no longer fit to serve as a risk indicator.
This will also have spillover effects on the equity markets that have to absorb part of the excess liquidity. Share valuations will be inflated to levels that have regularly proved unsustainable in the past.
Surging liquidity, more risk on the balance sheets of banks and insurers, sky-high valuations in individual asset classes -- these are some of the already visible consequences of the ECB's policy, and the trend is set to continue. It feels like the markets are programmed to crash when the ECB's QE program nears its end if not before.
Why is the ECB doing all this even though the risks appear to be so blatant? Well, the reason presumably lies in the shortcomings of the eurozone itself and its countries' governments. Their inability to make reforms is the main factor forcing the ECB into action. Continuing failure on the reform front would make the structural differences between member countries ever wider, runs the argument. This would make it even harder for unitary monetary policy to function effectively -- which would call into question the reason for the European Currency Union's very existence.
On this logic the ECB is therefore trying to fulfill its mandate within a further-deteriorating structural context and an inadequate institutional framework. Maybe it does not need to resort to such drastic means, but it is clear that many on the ECB's governing council do believe such resolve is needed to secure the eurozone's long-term survival.
We can only hope that the ECB's measures work. Should the positive growth effects fail to materialize, the end result could be to widen the divergences within the currency block and weaken the union as a whole. If this happens however, the responsibility will not lie with the ECB but at the door of the national governments that are not willing or able to adjust their economic policies to the needs that flow from membership of a currency union.