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Analysis
Bundesbank sets conditions for ECB QE programme

Bundesbank sets conditions for ECB QE programme

Germany wins opt-out on sovereign bond purchases 

by David Marsh

Mon 19 Jan 2015

In the shadowy world of European Central Bank decision-making, all central banks are equal – but some are more equal than others. The important concessions offered to the German Bundesbank to facilitate an announcement on sovereign debt purchases after the ECB’s meeting on 22 January could open further divisions within 19-member economic and monetary union – without guaranteeing the effectiveness of attempts to overcome the euro area’s low inflation and rebuild political cohesiveness.

A significant additional factor behind the complexity of the ECB’s discussions on full-scale quantitative easing is last week’s Swiss National Bank’s decision to end its unilateral peg, in force since September 2011, between the Swiss franc and the euro, leading to a sharp revaluation of the Swiss currency.

The revoking of the earlier Swiss pledge to buy ‘unlimited’ amounts of foreign currency to depress the Swiss franc has lowered the general credibility of central bank statements on exchange rates and removed a major source of euro support on markets. It exposes the SNB to heavy currency write-downs on its end-2014 foreign exchange holdings of more than SFr475bn, built up through unprecedented intervention to hold down the franc since the 2008-09 financial crisis. Switzerland's official reserves, up 10-fold since 2008, are now among the highest in the world, but will almost certainly be a major loss-maker for the Swiss state in 2015, with big political repercussions in Switzerland that will have an influence in Germany too.

Further, the Swiss climb-down revealed the full extent of euro bloc strains. The mechanism of the single currency has depressed the real (inflation-adjusted) value of the ‘German euro’ by at least 20% compared with its theoretical level outside EMU. Whatever happens on Thursday, the fragility, hesitancy and politicisation of the ECB’s decision-making are likely to drive the euro still weaker, without necessarily helping equity markets.

The ability of Jens Weidmann, the Bundesbank president, to promote his well-known concerns about risk-sharing into powerful conditions for a sovereign bond programme will astonish many who believed Mario Draghi, the ECB president, could push through full-scale QE without accepting German strictures.

The effective German opt-out from comprehensive support for other euro members greatly compromises the common monetary policy at the heart of EMU. It rekindles memories of the Bundesbank’s surprise revelation in September 1992 that it would no longer intervene to shore up the Italian lira in the exchange rate mechanism of the European Monetary System, EMU's forerunner. This loophole had been agreed in a secret document (‘the Emminger letter’) between Bundesbank President Otmar Emminger and West German Chancellor Helmut Schmidt in November 1978.

Latest manoeuvrings over QE, including talks last week between Draghi and German Chancellor Angela Merkel, bring to a head months of political infighting and legal investigation over whether the Bundesbank could use its shareholder rights at the ECB to block a measure that it believes would be ineffective, unnecessary and loss-making.

Draghi’s bowing to German demands that central banks make secondary market purchases only of their own countries’ bonds, and at their own risk, is an important concession, but does not remove all the political and technical obstacles.

The Bundesbank’s overt veto power exposes the limits of Draghi’s celebrated yet never-tested July 2012 declaration that the ECB would ‘do whatever it takes’ to shore up the single currency. German conditions for QE, which would effectively split off parts of the ECB balance sheet from collective EMU liability, still need to be framed in cast-iron legal language that would satisfy Bundesbank and Berlin government lawyers. The QE programme that ensues looks set to fall well short of the across-the-board quantitative easing that many financial markets practitioners had been expecting. By placing limits both on the ECB’s ability to act for all EMU members, and also on what Draghi has in the past called the ‘singleness’ of EMU monetary policy, acceptance of the Bundesbank conditions dramatically weakens the mutual solidarity that EMU is meant to incarnate.

As the Bundesbank has been hinting for months, Draghi's ability to outvote the German participants on the ECB governing council is more theoretical than real. The formal ‘one person, one vote’ procedures manifestly do not unconditionally apply for matters affecting the capital of the bank and individual nations’ risk-sharing.

Draghi’s QE concessions may not assure the programme’s size and effectiveness. As well as the details of the risk-sharing mechanism, the ECB needs to decide a quota system for individual countries’ purchases which will no doubt set a ceiling on overall transaction volumes. This will be complicated by the insistence of the Bundesbank and possibly of other central banks that QE transactions should neither include bonds yielding negative interest rates, nor should have a direct effect on interest rate-setting on the primary market. Both of these additional conditions will have an impact on the ECB’s intention to raise its balance sheet by €1tn in the next two years.

Many market participants previously betting on an unconditional Yes to QE on 22 January had been banking on Merkel backing Draghi against her erstwhile protégé Weidmann. They believed she would repeat her support for Draghi in September 2012 over the never-used Outright Monetary Transactions programme (which Weidmann opposed), foreseeing selective ECB bond purchases for countries that agreed additional austerity measures.

However, such interpretations ignore the very significant differences between the two episodes – a disparity which has now been placed on clear public view, with considerable potential for further political and financial turbulence.

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