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Analysis
Full-scale ECB quantitative easing less likely

Full-scale ECB quantitative easing less likely

Shock may be comparable to 1992 revelations on ‘Emminger letter’ 

by By David Marsh and John Nugée

Mon 13 Oct 2014

Full-scale quantitative easing by the European Central Bank through large-scale secondary market purchases of government bonds to raise euro area inflation is becoming ever less likely. This is partly a result of well-orchestrated opposition from the German Bundesbank. It reflects, too, the ECB’s belief that already-announced credit easing measures – including purchases of asset-backed securities and covered bonds – could soon start producing beneficial results.

European financial markets have been buoyed in recent months by hopes that, as European growth and inflation data worsen, the ECB would come to the rescue with dramatic asset purchase measures. 

Amid what amounts to unusual psychological warfare about full-scale QE among the ECB and some constituent central banks, realisation that such heavy-duty measures are highly unlikely could lead to a further sell-off of European equities. This could also widen price ‘spreads’ between bonds from Germany and other euro area countries.

Some market practitioners believe this could be a major test for economic and monetary union, two years after the last big crisis. In an uncannily similar episode 22 years ago, the Bundesbank invoked an opt-out for general intervention to support weak currencies in EMU’s forerunner, the exchange rate mechanism. 

While wishing to avoid a damaging confrontation with the ECB, the Bundesbank is exploring the legally ambiguous area of whether it could use its shareholder rights to block full-scale European QE that it believes would transmit wrong policy signals and expose it and German taxpayers to large capital losses.

German headwinds against QE constrain the ECB’s options in dealing with threatened deflation in Europe. This compounds a perception of policy paralysis in the face of gloomy German economic data and what the International Monetary Fund has termed a 40% probability of a new European recession.

Mario Draghi, ECB president, is aware of the potential for a German revolt. Like Jens Weidmann, the Bundesbank president, he wishes to avoid a showdown. Ahead of a public hearing at the European Court of Justice tomorrow over a separate German lawsuit on the ECB’s untested outright monetary transactions bond-buying programme, Draghi’s appetite may be limited for a new fight with the Bundesbank.

Potential shock waves from QE skirmishes could be comparable to upsets in September 1992 when European governments were told of the Bundesbank’s ability to sidestep an obligation to undertake unlimited currency intervention to support the Italian lira and French franc in the ERM.

The opt-out was contained in a shadowy accord in November 1978 between Otmar Emminger, then Bundesbank president, and Helmut Schmidt, German chancellor, in a document known to central bank historians as the ‘Emminger letter’. When Carlo Azeglio Ciampi, governor of the Banca d’Italia, was called to the telephone to be told of the Emminger letter during crisis consultations with Giuliano Amato, Italian prime minister, and Piero Barucci, finance minister, in Rome on 11 September 1992, he returned to the conferral ‘pale, almost white’, according to Amato. A key participant in subsequent wrangling over Italy’s devaluation and then withdrawal from the ERM was Mario Draghi, then director of the Italian Treasury.

Draghi’s 1992 experience is likely to colour his behaviour in any coming Bundesbank stand-off. Another key player sensing déjà-vu could be Michel Sapin, French finance minister, who held the same position in fraught devaluation tussling with Germany in 1992.

In the present imbroglio, full-scale QE would go well beyond the ECB’s ABS and covered bond purchases likely to be implemented in coming weeks despite Bundesbank opposition as well as separate threatened German legal action. Purchases by the ECB and its constituent central banks of a wide range of European government paper would be still more problematic than the OMT plan, laying down that the ECB would purchase the debt of hard-pressed euro members that enter into officially sanctioned structural adjustment programmes.

The OMT has not been (and may never be) implemented. Euro area bond market interest rates (and German bond spreads) have fallen so far since 2012 that it is not necessary at present. The necessary conditions for OMT, further economic adjustment programmes for debtor countries, would be deeply unpopular. Furthermore, Germany’s constitutional court has suggested that OMT is unlawful and has handed the case to the ECJ for a further legal opinion, which could still lead to a block on the Bundesbank’s involvement. 

In a view largely shared by the Berlin finance ministry, the Bundesbank believes implementing either OMT or full-scale QE would increase ‘moral hazard’, reducing the pressure for governments to carry out reforms the Germans say are essential to lower euro area imbalances and increase competitiveness.

Weidmann, together with three other European central bank presidents, voted against the ECB’s decision on 4 September to introduce limited QE through the ABS and covered bond programmes.

The Bundesbank believes purchases of large quantities of government bonds at a time when prices are already very high could make it and other central banks vulnerable to big portfolio losses. Over the past four years, under the ECB governing council’s normal procedures where each member of the now 24-strong body has one vote, Weidmann and his predecessor Axel Weber have been overruled on several key decisions. However, the Bundesbank president may argue that articles 10.3 and 32 of the ECB statutes, allowing use of the ECB’s so-called capital-weighted voting procedures in certain cases, apply to decisions on QE, since this could create the need for compensation ‘in exceptional circumstances for specific losses arising from monetary policy operations.’

Invoking the Bundesbank’s rights would make solely the presidents of the 18 euro area national central banks responsible for a decision on QE. Representing the largest ECB shareholder, Weidmann would have 26% of the votes. If the council ruled that such approval required a qualified majority of two-thirds of the bank’s subscribed capital, Weidmann could relatively easily muster a one-third veto by garnering the support of the national central banks which voted against ABS on 4 September.

Draghi would be uncomfortable about engineering a high-stakes legal confrontation with the Bundesbank that he could lose.  Rather than recommending full-scale QE, the ECB might decide a more low-key approach that would effectively give the Bundesbank a QE opt-out. It could appoint national central banks as 'discretionary agents' authorised to buy their own government's bonds for the ECB's account, up to individual specified amounts. This would allow notional QE, but with Germany on the sidelines, leaving the funding and the risks to the others.

Such an outcome would be sub-optimal. Both Draghi and Weidmann would like to ensure that such a demonstration of disunity never comes about. However, with pressure building up from different directions, and despite the sobering lessons of history, the possibility of some form of damaging split is far from negligible.

David Marsh and John Nugée are board members of OMFIF.

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