ECB faces difficult choices on QE
by Ben Robinson
Long-term weaknesses in Spanish and Italian banks came to the fore in June with the dismantling of two Italian banks, the rescue of a third, and the resolution of Banco Popular, Spain’s sixth largest bank. These cases raise fresh doubts about the European banking system and the measures needed to address weaknesses.
For creditors like Germany, the prospect of additional financial support for periphery country institutions, including extending the European Central Bank’s quantitative easing programme, gives rise to uncomfortable political implications.
However, in some ways the ECB has already bolstered its support for struggling countries. Despite officially reducing the size of its asset purchase programme to €60bn a month since April, down from €80bn, it has overshot this by over €2.5bn on average each month. Since the beginning of the year it has significantly increased the amount of Italian bonds purchased under QE, exceeding Italy’s ‘capital key’ allocation by more than €5.2bn (9%).
Shifts for eligible bonds
The over-purchase of Italian bonds is not a new phenomenon. A lack of eligible bonds in some European countries, including Portugal, Ireland, Slovakia and Slovenia, means some adjustment is required via increased purchases elsewhere. The scale, however, has increased rapidly. The ECB has over-purchased Italian bonds by an average of €869m per month since January, against a monthly average of €264m from the start of public sector bond purchases in March 2015 to the end of 2016 (see Chart).
This may suggest a lack of eligible bonds in larger countries, most notably Germany, where the ECB has started under-purchasing. May was the first time that the ECB bought fewer German bonds than its capital key allocation for the second consecutive month. June marks the third month in a row. Under-purchases since April total almost €1bn, against a total of just €247m for the entire period of QE up to March. Finland and the Netherlands have also seen a significant under-purchase of bonds by the ECB. Although it may be premature to conclude too much from this, should the trend continue it will raise questions over the future of QE.
Figures from the end of June show euro area inflation fell to 1.3% from 1.4% in May. This suggests monetary policy operations to boost inflation, including bond purchases, still have further to go. However, without an adjustment of the asset purchase rules, German bonds may reach their limit under the public sector purchase programme.
Prospects for adjusting QE rules
In January the ECB governing council modified the public sector purchase rules to allow the inclusion of bonds with yields below the deposit facility rate of minus 0.4%. This will primarily benefit German bonds. The weighted average maturity of German bonds has fallen to 7.14 years in June from 8.16 years in December, reflecting the shorter maturity of new bonds purchased. These bonds have yields below the ECB deposit rate.
Despite these tweaks, there are limits to how far purchases of German bonds can go, given other restrictions, including limitations on the amount of any one country’s issuance that can be bought by the ECB.
Fundamentally, adjusting the rules to allow the ECB to keep purchasing German bonds, in order to justify continued purchases of Italian, Spanish and other bonds, is unlikely to satisfy critics. Germany and others have long argued for a scaling back of QE, with a view to eventually winding it down altogether.
Yet a scaling back of QE would cause bond yields and the euro to spike, as they briefly did on 27 June after ECB President Mario Draghi seemed to suggest the Bank could soon begin tapering the bond purchase programme. Senior ECB sources intervened by saying Draghi’s comments had been misinterpreted.
The yields on Italian and Spanish government bonds had been rising steadily since the start of 2016, reaching 2.5% and 1.5% respectively in March 2017, before falling back slightly. The impact of a further rise in yield for periphery countries’ financial institutions, including those of Italy, Spain and Portugal, could be significant.
Worrying widening of Target-2 balances
These worries are contributing to the continued widening of Target-2 balances, with German claims on the ECB standing at €857bn at end-May, a record high. Italy’s liabilities have reached almost €422bn, far above their previous peak of around €290bn in 2012. Spanish liabilities are almost €376bn, their highest since end-2012. Both countries’ balances are still rising.
There are nuances surrounding Target-2 balances, including the influence of clearing houses in boosting the recorded claims of Germany, Luxembourg and the Netherlands, as well as important differences with 2012, when concerns over liquidity were paramount.
Nevertheless, rising balances raise questions about the smooth running of the financial system in case of a scaling back of expansionary ECB policies. The divergent strengths and weaknesses of euro area economies make the task of monetary policy normalisation highly complex – but the risks of interminable QE are becoming increasingly clear.
Ben Robinson is Economist at OMFIF.