A Silver Bullet for the European Crisis

A Proposal for The European Quantitative-Easing Intermediated Program (EQUIP), by the School of European Political Economy at LUISS University – Rome (SEP)

The European Central Bank (ECB) has recently acknowledged the dangers of a prolonged period of overly low inflation in the euro area. In fact, in recent months inflation developments have continued to surprise on the downside. The level of consumer prices has declined from a high of more than 3 percent at the end of 2011 to a low of 0.3 percent in the last months, and recent weakness in wage growth casts doubt on the possibility that domestic price pressures will strengthen in the near future. The latest ECB staff projections foresee that by the end of the projection horizon, annual Harmonized Index of Consumer Prices (HICP) inflation will still fall short of its target of a rate of inflation of below, but close to, 2 percent over the medium term. According to the central bank, “recent data concerning medium-to-longer term inflation expectations are acknowledged as a cause for extra vigilance.”[1] In other words, the main goal of ECB monetary policy, i.e. price stability, is at risk as market participants expect inflation to remain well below 2 percent in the next five to 10 years. The dreaded scenario of prolonged low inflation seems more realistic today than it ever has in the past.

ECB board members are adamant about the fact that the dangers of low inflation affect the overall stability of the euro area: “Excessively low inflation rates made it harder for stressed countries to adjust their economies and regain competitiveness. “We [could] soon find ourselves in a vicious circle in the euro area.”[2] Lower than expected inflation rates “would increase the real value of debt, slowing down the deleveraging process of borrowers, both public and private. The increase of the debt overhang burden would also be detrimental to debt sustainability and to growth. This does not imply any scenario of deflation, in which we do not believe, but depends exclusively on the materialization of a prolonged period of low inflation and low real growth.”[3]

It was against this backdrop of a persistently weak inflation outlook, a slowing growth momentum and subdued monetary and credit dynamics that the ECB decided on a package of measures between June and October to provide further monetary policy accommodation and support lending to the real economy. However, doubts have grown about the efficacy of conventional monetary policy instruments (LTRO, VLTRO, TLTRO) which rely on the credit demands by the banks and the real economy in the face of continuously sluggish money and credit dynamics. The choice of activating the TLTROs follows the long-standing monetary policy tradition in the eurozone, which, in view of a bank-centered financial structure, is based on lending to counterparties. As the ECB acknowledges, “inevitably, this makes the overall scale of the measures to a large extent dependent on banks’ autonomous decision to participate and borrow, which is itself influenced by banks’ appraisal of the strength of the recovery and the prospects for a sustained rebound in credit demand. In conditions in which these expectations may be re-appraised, the force of the overall monetary policy stimulus that can be expected to be introduced through the TLTRO is bound to become more uncertain.”[4]

In this context, the size of the Eurosystem balance sheet has attracted attention among ECB observers. With liquidity depending on the weak credit demand by banks, the size of the ECB balance sheet has kept declining in the recent years and months. In this respect, the ECB has remained isolated from other central banks that instead have increased the size of assets held against the provision of liquidity to the economy. In a public hearing at the European Parliament, President Mario Draghi announced that the ECB balance sheet “is expected to move towards the dimension and the size it had at the beginning of 2012”, implying an increase in asset purchases of about 1 trillion euros.

In order to expand its balance, the ECB decided that the liquidity injections through the TLTROs need to be accompanied and reinforced by asset-backed securities (ABS) and covered bond purchases. The purchase of covered bonds has already started. However, the capital market segments targeted by the ECB purchases are not as deep and liquid as their equivalents in other leading economies. This is particularly the case for the ABS market, which has yet to recover from a protracted period of minimal issuance activity and disappearing trading traffic. ECB intervention will, in itself, partly mitigate this problem by encouraging issuance activity as well as the unfreezing of ABS and covered bonds that are currently retained on intermediaries’ balance sheets. However, these dynamic effects are difficult to estimate precisely. In fact, there is a high probability that the purchases of private securities, ABS and covered bonds, fall remarkably short of the desired target of 1 trillion euros.

It is possible that the ECB finds necessary to expand its purchases to the wide market of eurozone public securities, resorting to sovereign quantitative easing (QE), or large-scale central bank purchases of government debt.

Our proposal is intended as a contribution to the current analysis of sovereign QE that the ECB has already initiated through its internal working groups. Given the aforementioned premises, there is a specific opportunity in sovereign QE that could be a game-changer in the course of the European economic crisis.

The eurozone has the peculiarity of not being able to rely on the existence of a liquid and public security representing the whole area. On the contrary, the euro area is characterized by the existence of different public securities representing each single member state. As such, it is likely that the ECB will decide to purchase public securities of all countries in distinct quantities approximately replicating a pre-fixed key as close as possible to the ECB capital key representing each state’s contribution to the ECB capital.

The ECB intervention would be less distortive and more effective if it could leverage on the existence of a liquid market for a public security representing the eurozone as a whole, based on the securitization of the different underlying national public securities. It would consist of an ABS of the existing eurozone public securities composed according to the pre-defined key. The creation of such a security would be a private initiative of financial intermediaries, under condition that the ABS respects the pre-defined qualifications provided for by the ECB. The ECB itself could announce that it would consider such a security – mirroring the key of its sovereign bonds purchases in a fixed proportion that should be clearly announced at the beginning of the program and would de facto create a basket of sovereign bonds – eligible in its purchase programs both in the context of QE and outside of it, supporting a European Quantitative-easing Intermediated Program (EQUIP).

The new ABS would not be an attractive innovation for the ECB only, but would greatly benefit private investors, both European and non-Europeans, who are longing for a European liquid and safe asset. Market makers engaged in the EQUIP would provide liquidity for an important segment of financial markets, reducing the transaction costs for the basket of national public securities.

If the total amount of QE is estimated at 1e trillion euros, the market behind the new security would amount to one of the largest in global finance. A group of financial intermediaries, mainly the largest government bond market makers, would be called upon to set up the market for the new security. Private actors might find attractive to create and trade a security which finds an ultimate purchaser in the ECB in the context of the QE program. In other words, liquidity of the new asset would be assured. Since its outset, and even since its announcement, the gradual program of purchases – the Federal Reserve purchased a monthly amount for several years – would motivate the private economy to develop immediately a large supply of the new security amounting to a significant share of the total QE program.

EQUIP would, by no means, imply a burden sharing of public debts between states or between debtors, because ABS would carry the same risk-yield of its underlying components, taking into account the yield correlations.

The Consequences of EQUIP

The consequences of the EQUIP program might be sizable:

• The signaling effect of the new common European security would be very significant as it aligns the authorities’ commitment to saving the euro with the interests and engagement of the private economy.

• The new EQUIP security would represent a new European safe asset which is coveted by global investors lamenting the absence of just such a European assets. It would create a market similar in size to the U.S. Treasury bond.

• Because it would mirror the weighted risks of its single underlying components, the new ABS safe asset would carry a higher – or more normal – yield than the safest among national public securities in the eurozone, which have caused concern in Europe due to their low levels. 

• It would engage the private economy and spur a close scrutiny by private investors of eurozone financial conditions as a whole, but preventing the formation of a “bad equilibria” mechanism.

• If largely held in the portfolios of eurozone banks it would contribute to decoupling of the risk ratings of individual banks from that of the sovereign debt of their home countries.

• Granting some degree of normalization in the level of European safe asset yields, it would allow for an improvement in the financial conditions in which some intermediaries operate, starting with pension funds and insurance companies in the core countries.

    [1] “Recent monetary policy measures supporting the euro area recovery” Speech by Peter Praet, Member of the Executive Board of the ECB, at the IIF Annual Membership Meeting, Washington D.C., 10 October 2014
    [2] “Low inflation as a challenge for monetary policy and financial stability?” Speech by Sabine Lautenschläger, Member of the Executive Board of the ECB, Parliamentary Evening, Hamburg, 7 July 2014
    [3] “Maintaining price stability in the euro area” Speech by Vítor Constâncio, Vice-President of the ECB, at the 18th Annual Central Bank and Investment Authority Seminar organized by Commerzbank, Berlin, 16 October 2014
    [4] Praet, ibidem