Gibran WATFE, 4 December 2015
Yesterday, the ECB announced an extension of its quantitative easing (QE) programme that was started in March this year. Apart from extending QE for at least six months to March 2017, Mr. Draghi, the President of the ECB, announced a widened scope of the programme. Only certain types of assets are allowed to be bought as part of the QE programme. This included, so far, sovereign and supranational bonds, as well as asset-backed securities and covered bonds. Yesterday, the list of eligible assets was extended to regional and local government bonds. Why did the ECB do this?
The background of the decision
Seeing that both inflation and growth continue to be at very low levels, the ECB was more or less forced to extend its monetary easing stance. For that purpose, various possible measures were conceived in the weeks and months before. However, a problem that has worried market participants soon after the QE purchases were started, was that there may not be enough government debt available. Even if absolute amounts of public debt are high in the euro area, the ECB could severely hamper the functioning of sovereign bond markets if it buys too much of the stock of a sovereign’s debt. In that case, the bonds that remain on the markets may become illiquid because there is only a small number of bonds left for trading. This would increase the yields on those bonds as investors would demand an illiquidity premium for the additional risk.
A problem for whom?
This problem, however, is not as serious for all euro area countries alike. In particular, the German Bundesbank seems to have trouble to find enough German bonds on the market. This is considered to be due to two reasons. First of all, the German government has not issued new debt in recent years as it wants to achieve a balanced budget. Second of all, since the euro area sovereign debt crisis, German government bonds have become the safe assets in the euro area and the European Union. They are therefore in high demand, both from European and external investors (see here an article describing how the German Bundesbank convinced the Chinese to let go of some of their stocks of German sovereign bonds).
Would the extended scope of the QE alleviate this problem? When looking at data from the OECD, it certainly looks like it. The share of subnational government debt in total general government debt is the highest in Germany with more than 35%. Estonia and Spain are the only countries that come close to this level with around 30%. Hence, yesterday’s decision of the ECB to extend QE to subnational debt seems to be targeted mainly at Germany and Spain.
For the Bundesbank, the decision means that the pool of potential assets to buy under QE increased by a third. It is thus much more likely to find bonds to fulfill its monthly purchase target. How much of subnational debt will they buy? Mr. Draghi was quick to announce that any such estimate would be premature. This points to the discretion that national central banks continue to have for the decision on which types of assets to buy.
What will be the effects?
In the first place, this move should certainly alleviate the concerns of market participants that the ECB might at some point not be able to deliver on its QE target because of a shortage of eligible bonds. This was likely the most important consideration of the ECB Governing Council that motivated its decision. It might have also led the ECB to refrain from extending the volume of monthly purchases, which was expected by the markets.
A second direct effect of this decision, given that subnational bonds will indeed be purchased, will be a reduction of financing costs for local and regional governments. This effect will be strongest in Germany, as the share of subnational debt is also the highest. This would help the German government to reach its target of a balanced budget. It could also act as an incentive to embark on expansionary fiscal policy in the coming years.
Therefore, the decision to include subnational debt could help reducing German opposition towards the QE programme. Once more, this move thus shows the ingenuity of Mr. Draghi to act in the interest of both operational efficiency and political reality at the same time.