ECB adds another half trillion in QE, even as Italy eyes debt cancellation
The central bank is in effect holding the fort through the worst of the crisis and shielding vulnerable states from markets until late 2021
The European Central Bank has stepped up pandemic emergency stimulus by another €500bn to counter a double-dip recession, but stopped short of ‘shock-and-awe’ measures to reverse a corrosive slide into deflation.
Bond purchases will be stretched out to 2022, clearing the way for the ECB to mop up three quarters of all fresh debt issuance by eurozone governments next year. This further obliterates the line between fiscal and monetary policy, and pushes the ECB’s balance sheet beyond 70pc of GDP.
The central bank is in effect holding the fort through the worst of the pandemic and shielding vulnerable states from the markets until the EU’s €750bn Recovery Funds starts to feed through in late 2021.
The package of measures amounts to Japanese-style "yield control", sending a message to markets that the ECB will hold down long-term interest rates across the board and for the foreseeable future, regardless of underlying credit worthiness or moral hazard.
The policy was signalled weeks ago and has set off a speculative ‘convergence play’ as funds rush to buy southern European debt and reap quick gains on capital appreciation.
“The ECB is telling us that their job is to keep borrowing costs as low as possible and these bonds are an absolutely safe investment. We’ve never had that kind of explicit message before,” said Marchel Alexandrovich from Jefferies.
Yields on 10-year Spanish bonds touched zero for the first time on Thursday. Italian bonds were trading at negative yields on maturities out to five years, even though Italy’s debt has rocketed to nosebleed levels of 161pc of GDP this year and the country is implicitly insolvent.
Professor Moritz Kraemer from Frankfurt’s Goethe University said the ECB has already pushed QE long past the point of diminishing returns and that further purchases will gain little economic traction. “Its strategy has stopped stimulating credit and demand. The only thing that it is achieving now is pushing yields even lower and blowing bubbles,” he said.Any benefits may be overwhelmed by the surging euro, which is fast turning into a terms of trade shock . The trade-weighted euro index has jumped 7pc this year and is flirting with an all-time high.
This is vastly complicating the ECB’s attempts to stave off deflation, with all the destructive pathologies that come in its wake. Headline inflation has dropped to minus 0.3pc and core prices may go negative over the winter.
Christine Lagarde, the ECB’s president, said the bank is monitoring the exchange rate “very carefully” but attempts to talk down the euro are likely to fail.
The ECB lacks the tools to fight appreciation in the face of a structural bear market for the US dollar and other currencies linked to it, directly or indirectly, including the Chinese yuan. Europe risks being the region that ends up holding the unwanted parcel that everybody else manages to pass on.
Frankfurt resisted the temptation to cut interest rates further below minus 0.5pc, knowing that Washington would deem this to be thinly-disguised currency manipulation. The Bank of Japan was warned in harsh terms when it tried to play this game.
In any case, negative rates have serious side-effects and erode the bread-and-butter business model of banks. The ECB has sought to blunt this with a technical device known as ‘tiering’ and has now extended ultra-cheap loans to commercial lenders at rates of minus 1pc for another year.
Nevertheless, there are signs of an incipient credit crunch in Europe as the delayed effects of the Covid recession become apparent and moratoria expire. Banks have begun to choke lending. They are demanding more collateral to protect themselves from a cascade of defaults.
The European regulator warns that bad debts in the banking system could hit €1.4 trillion, dwarfing the damage from the global financial crisis in 2008 and leaving many lenders under water.
The ECB’s blanket of QE has bought time but it has also made the system inherently more unstable. It has induced banks to feast on eurozone sovereign debt, two-thirds of it issued by their own national governments. Holdings have surged by €400bn this year to a record €1.86 trillion.
The unresolved ‘doom-loop’ of sovereigns and banks - each dragging the other down in times of stress - is now bigger than ever. EU leaders vowed eight years ago to sort out this systemic design-flaw but lost interest after the debt crisis faded. They never completed the banking union and there is still no pan-EMU deposit insurance.
The ECB is in an invidious position. It cannot easily stop buying Club Med bonds without risking a financial chain-reaction. Italy, Spain, or Portugal could turn to the EU bail-out fund (ESM) for support in extremis but they would not do so lightly given the conditions attached. Any move to push Italy into this sort of troika regime might destabilize the current pro-EU government and set off fresh calls for a return to the lira.
For now Germany is going along with ever more QE. It has reshuffled €140bn of its own internal debt to make the latest move easier. This sleight of hand allows the ECB to keep buying more bonds without deviating so visibly from its sacred capital key.
While the details are abstruse, the political signal is not. Chancellor Angela Merkel has clearly opted to let the ECB continue carrying the load for the whole EMU system - faute de mieux - even if that stores up large problems for the future.
However, it is an open question whether this implicit strategy will pass muster at the German Constitutional Court - or the anti-elite ‘people’s court’, as the chief justice called it after its last thunderous ruling against QE.
There is a strange dissonance to extra bond purchases at a time when Italian leaders and politicians are calling ever more loudly for cancellation of the ECB’s existing holdings. Demands for debt forgiveness on pandemic QE come from across the political spectrum, including close aides of premier Giuseppe Conte.
Matteo Salvini’s Lega party says the digital debt is an accounting fiction and should be wiped clean with the click of a mouse. The European Parliament’s Italian president David Sassoli is flirting with the idea. The demands have reached the front page of Avvenire, the voice of the Italian Catholic bishops’ conference.
Holger Schmieding from Berenberg Bank said the concept is lunacy and would backfire horribly. “People calling for this either don’t understand what they are asking for, or there is really something else behind it, and that is what could set off a run on the debt markets,” he said.
Legally and technically, it is the Bank of Italy that would be on the hook for most of the €550bn of Italian debt bought under the various QE schemes, not the ECB as such. One branch of the Italian state would therefore be forgiving another branch. The Italian treasury would have to issue extra debt to recapitalize a bankrupt Bank of Italy.
Mr Schmieding said investors would see the gambit as a “trial run for a broader debt restructuring at their expense”. Risk spreads would soar and Southern Europe would be thrown back into a debt crisis.
For Italy, such a radical move would make sense only if it was part of a much larger debt restructuring and a lira redenomination. That would entail a partial default by the Bank of Italy on its €520bn of Target2 liabilities to the ECB under the principle of Lex Monetae. This would be a financial earthquake for Europe and the world.
For the time being, the ECB is doomed to keep sinking deeper into this debt trap even though everybody knows that QE has become a disguised monetary bail-out for insolvent states. In other respects it probably has no more economic potency at this juncture than a rain dance.
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