We destroyed the myth that the LTRO would not in fact stigmatize bank balance sheets when it was first introduced as the encumbrance was evident from the start - though took the market a while to comprehend and reprice (exuberant on the new-found liquidity optics). The expectations that the ECB will embark on a new scheme of sovereign debt purchases, implicitly funding governments - no matter how many times they tell us that it is to ensure transmission mechanisms flow, have three objectives or rationales, according to Goldman's Huw Pill: Easing private financing conditions through monetary expansion, Financing governments, and/or Reactivating private markets. However, there is one glaring unintended consequence of this 'aid' - the risk exists that well-intentioned sovereign debt purchases result in perverse incentives and a perpetuation of chronic fiscal and structural problems (much as Bernanke's band-aids have eased the fiscal pressure on our own government and led us further down the rabbit hole). The lack of political legitimacy and blunting of incentives for more fundamental consolidation and reform to take place can only turn the acute pain of the moment in Spain into a truly chronic problem for Europe as a whole - be careful what you wish for.
Goldman Sachs: Three Rationales For Sovereign Debt Purchases
We expect the ECB to announce a new scheme of sovereign debt purchases aimed at reactivating and reintegrating Euro financial markets to ensure monetary policy transmission. We compare this rationale with other motivations for central bank purchases of government debt. In the end, purchases will serve several ends. The risk exists that well-intentioned sovereign debt purchases result in perverse incentives and a perpetuation of chronic fiscal and structural problems. Guarding against this risk, while still offering meaningful support to peripheral sovereigns, remains an important challenge for ECB policies.
Attention remains focused on the ECB’s September Governing Council meeting. In August, the ECB announced that it would recommence sovereign debt purchases, so as to contain ‘convertibility risk’ (i.e., the risk of a Euro break-up and/or exit). But the modalities of how these interventions will be implemented remain under discussion. The operational specifics are controversial, as recent comments by ECB policy makers demonstrate.
Last week, we outlined our expectations of what the ECB will announce next Thursday. In short, for countries that have made a request for EFSF / ESM assistance and accepted the implied conditionality, we expect the ECB Governing Council to:
- Show preparedness to intervene at the short end of the sovereign yield curve in an opportunistic manner so as to contain spikes in short-dated peripheral government yields, pre-empting the periodic market seizures that have been associated with such spikes in the past;
- But eschew ‘hard’ caps on yields or spreads and/or mechanical ex ante intervention rules that would limit the operational flexibility of the ECB to choose the magnitude and timing of specific interventions.
Rationales for central bank sovereign debt purchases. When assessing such mechanisms, it is valuable to consider the objective of the bond purchase scheme. Here, comparisons with the experience of other central banks can be informative.
We identify three rationales for such purchases, noting that they need not be mutually exclusive. Indeed, by their nature, central bank purchases of sovereign debt will have implications across all three dimensions.
- Easing private financing conditions through monetary expansion. The quantitative easing (QE) programmes undertaken by the Federal Reserve and the Bank of England have aimed at easing financial conditions. Most narratives have emphasised the role played by portfolio balance effects. By making money-financed purchases of sovereign debt from the market, these central banks have shortened the average duration of private balance sheets. As private investors attempt to rebalance their portfolios in response, they buy longer-dated assets to increase the duration of their holdings, thereby driving up the price of equities and bonds. This leads to lower financing costs for borrowers. Such mechanisms allow monetary policy to ease financing conditions even once the lower bound on nominal interest rates has been reached.
- Financing governments. Central bank purchases of sovereign debt in the primary market constitute direct monetary financing of governments. Given concerns about the inflationary impact of such purchases – amply demonstrated by history, with the Weimar experience weighing heavily on German attitudes – they are prohibited by the Lisbon Treaty (the relevant clause – Art. 123 – is applicable both to the ECB and to other EU central banks, including the Bank of England) and many other central bank laws. Purchases in the secondary market can also support government financing, for example by suppressing sovereign yields. In the limit, secondary market purchases can be functionally equivalent to primary purchases, if an intermediary simply stands between the sovereign issuer and the central bank purchaser to circumvent any prohibition on primary market purchases.
- Reactivating private markets. Finally, central bank purchases can be used to reactivate markets that have seized up on account of information or coordination problems. For example, should a sovereign with a fundamentally sound fiscal position face a market sceptical of its solvency or commitment to the Euro, borrowing rates will rise as a credit and/or convertibility risk premium becomes embedded in government yields. But that rise in yields, by its nature, increases sovereign funding costs and could validate concerns about fiscal sustainability and/or Euro exit. The government may be trapped in a high interest rate / high default risk equilibrium, even though another, more desirable low interest rate / low default risk equilibrium exists. Well-designed interventions by the central bank can shift the market to the more desirable situation. Since the main concern is rolling over outstanding debt at sustainable rates, interventions at the short end of the maturity spectrum may suffice. And – since sovereign markets are integral to the functioning of the broader financial system – such actions can yield significant broader external benefits in terms of improving the functioning of financial markets and institutions.
The ECB’s approach has focused on market functioning ... The ECB has motivated its prospective sovereign debt purchases under the lattermost of these three rationales.
- Given the Treaty’s prohibitions, an explicit attempt to finance peripheral governments would trigger legal challenges and undermine the ECB’s hard won credibility;
- And the need for explicit QE in the Euro area is seen as more limited than in the US or UK: first, the ECB still has scope to lower its policy interest rates and so can ease monetary policy through more conventional means; and second, the Euro financial sector is already awash with excess liquidity as a result of the large 3-year LTRO operations conducted last December and February.
Mr. Draghi has correctly identified the segmentation and dysfunctionality of Euro financial markets as an impediment to the transmission of the single monetary policy, which needs to be overcome if monetary union is to be workable. The measures we expect to be announced next week – which can be characterised as an attempt to promote the reactivation and reintegration of sovereign markets – will act in this direction.
While necessary, these measures alone are unlikely to be sufficient. Funding problems for peripheral sovereigns undermine their domestic bank systems and hinder credit supply. As we have argued previously, to improve monetary transmission and ensure monetary stimulus reaches its target – notably, the peripheral private sector – additional, more targeted credit easing measures (e.g., further widening of collateral eligibility, lowering of haircuts and purchases of private sector assets) may be required.
...but the other rationales may (soon) come into play ... We would not rule out that the ECB eventually implements QE-style measures, should ECB interest rates reach their lower bound and the macroeconomic outlook deteriorate further. An emergence of deflationary risks would make such actions wholly consistent with the ECB’s mandate.
But the efficacy of such measures is open to question. Excess liquidity at present accumulates in the core countries, easing financing conditions via the portfolio balance channel in Germany where such stimulus is little needed. At the same time, market segmentation means that this easing has little impact on the periphery:
German investors with excess liquidity remain reluctant to purchase Spanish or Italian bonds, thereby leaving peripheral yields at elevated levels while German yields fall to historical lows. Reintegrating markets is a precondition for monetary policy transmission, whether for conventional actions (i.e., interest rate changes) or unconventional actions (such as QE).
...which, although perhaps inevitable, comes with attendant risks. Financing governments explicitly will run into immediate legal and institutional barriers. But, under the cover of supporting market functioning, scope also exists for central bank purchases of government debt to support sovereign funding.
Indeed, it must do so. For all the protestations of the Federal Reserve and Bank of England that QE measures are wholly monetary in nature, they have eased the funding of the US and UK Treasuries. By the same token, ECB purchases of peripheral sovereign debt will help finance peripheral governments.
Such support may be necessary and inevitable. The resources of the EFSF / ESM have long been seen as insufficient to meet the financing needs of Spain and/or Italy in a credible way. Mobilising the ECB balance sheet in parallel with EFSF / ESM actions provides capacity for the necessary volume of purchases, while maintaining the conditionality that was absent from the ECB’s previous securities markets programme (SMP). Taking a sympathetic view, the envisaged ECB measures can be seen as a proactive attempt to create a framework that allows such financial support to be offered to peripheral governments in a structured and limited manner.
But such measures come with risks. Both the strength and the weakness of central bank financing will soon become apparent. As a flexible and immediately available source of sovereign funding, central bank financing is a powerful tool to deal with crisis situations. But it lacks political legitimacy and can blunt the incentives for more fundamental consolidation and reform to take place, helping to transform a crisis into a chronic problem.