The case for the ECB sovereign bonds purchases
On Thursday July 5th the ECB decided to cut its main refinancing rate to 0.75%, for the first time crossing the historical low of 1%. More importantly, it reduced the overnight deposit facility rate to 0%. In doing so, the ECB encouraged banks to transform the liquidity received via two 3-year LTROs into credit to companies and households, instead of keeping it at the ECB deposit facility.By Urszula Szczerbowicz
Post, July 10, 2012
The ECB decision to cut interest rates, largely expected, was not sufficient to reassure financial markets. Italian and Spanish long-term interest rates rose and the stock markets went down following the ECB decision. It seems that market participants were awaiting further unconventional measures while Mario Draghi dampened hopes on further development of these tools in the near future.
Since the beginning of the subprime crisis the ECB has implemented several non-standard policy measures. Due to disruptions in several segments of financial markets, traditional monetary transmission channels were impaired and the policy rates did not affect other interest rates to the extent they used to before crisis. The ECB operation framework was flexible enough to be adjusted promptly to new circumstances and the following unconventional measures were introduced: a) unlimited provision of liquidity through “fixed rate tenders with full allotment”; b) lengthening of the maturities of the refinancing operations up to 3 years; c) liquidity provision in foreign currencies; d) wider range of collateral accepted; e) outright purchases of covered bonds; f) purchases of government bonds through the Securities Markets Programme (SMP).
Other central banks have also implemented unconventional monetary policies which have gradually become “mainstream” monetary framework. There is a rapidly growing literature about the theoretical channels and empirical effectiveness of these alternative policies, on the one hand, and on the risk they entail to the central bank balance sheet and credibility, on the other hand. Among non-standard measures, the purchases of sovereign bonds seem to be the most controversial one as they raise questions about the separation of monetary and fiscal policy. In case of national central banks, outright purchases of sovereign debt in parallel to government fiscal stimulus might encourage expectations of the growing public debt monetization. In the euro zone, the ECB decision to purchase bonds of Southern European countries raises concern about the ECB arbitrarily choosing to diminish borrowing cost of specific governments. Furthermore, the risk that the central bank took on its balance sheet might endanger the pursuit of its primary mandate, that of price stability.
The sovereign bonds purchases are therefore a politically sensitive subject and the introduction of the SMP was followed by a wide debate on its potential damages to the ECB credibility. While the question of whether the ECB should be responsible for these purchases is a valid one, it is important to evaluate the effectiveness of the measure itself and the support that it has been given by theoretical and empirical studies.
The theoretical models predict indeed that decreasing supply of a security raises its price. Long-term bonds purchases should therefore be successful in lowering long-term interest rates by reducing the risk premium (Vayanos and Vila, 2009). The empirical evidence confirms that the quantitative easing in the U.S. and U.K. reduced the long-term yields and therefore the borrowing cost to governments, companies and households (See Krishnamurthy et al. 2011 and Szczerbowicz 2011 for the U.S. and Joyce et al. 2011 for UK). As far as euro area is concerned, I conducted an event-based regression study in order to compare the impact of different unconventional ECB measures on reduction of market borrowing conditions for banks and governments. The results show that the SMP lowered significantly and importantly the long-term sovereign spreads for Southern European countries. The effects, based on the one-day financial assets response, range from 25 basis points (Italy) to 376 basis points (Greece). As a comparison, the U.S. and U.K. sovereign spreads (measured as a difference between long-term government yield and risk-free interest rate swap) also fell following the quantitative easing implemented by the Fed and the Bank of England but the magnitude of the effect was much smaller: respectively 8 and 9 basis points. The strong impact in the euro zone suggests that the central bank intervention in sovereign market is particularly effective when the sovereign risk is important.
It has been pointed out that the SMP has failed to bring down yields permanently. While this is certainly true, one must bear in mind that there is no measure capable of achieving that in times when every week brings more uncertainty concerning the final outcome of the euro area sovereign debt crisis.
The euro zone economy is being increasingly compared to the Japanese “lost decade” economy: undercapitalized and deleveraging banks, lack of viable investment opportunities for firms, policy rates close to zero... It seems therefore important to take into account the lessons from Japanese experience. The Bank of Japan was the first to increase its balance sheet in order to spur the aggregate demand. However, this increase was very limited compared to the current central banks’ balance sheet expansion (about 50% between 2001-2006 vs. 230% for the Fed and 150% for the ECB since 2007). Furthermore, it was achieved in balanced proportion through long-term bonds purchases and through short-term funds-supplying operations to commercial banks. This type of “non-aggressive” quantitative easing failed to stimulate the economy. The loans distributed to undercapitalized banks did not turn into credit to companies and households and the quantity of long-term bonds purchases was not important enough to modify their yields and prices (monthly purchase of 400-1200 ¥ billion, that correspond roughly to 3,5 – 10 $ billion, to be compared to the Fed’s QE2 monthly purchases of 75 $ billion).
There might be an additional advantage of buying government bonds according to empirical studies (Krishnamurthy et al. 2011 and Szczerbowicz 2011): it can increase long-term inflation expectations. This is not the effect that the ECB is searching for at the moment, but when the policy rates get closer to zero it is good to know that tools exist to counter the deflationary expectations.
Joyce Michael A. S., Ana Lasaosa, Ibrahim Stevens and Matthew Tong, 2011. "The Financial Market Impact of Quantitative Easing in the United Kingdom", International Journal of Central Banking, vol. 7(3), pages 113-161, September.
Krishnamurthy Arvind and Annette Vissing-Jorgensen, 2011. "The Effects of Quantitative Easing on Interest Rates: Channels and Implications for Policy", NBER Working Papers 17555, National Bureau of Economic Research, Inc.
Szczerbowicz Urszula, 2011. "Are Unconventional Monetary Policies Effective?", Working Papers CELEG 1107, Dipartimento di Economia e Finanza, LUISS Guido Carli.
Vayanos Dimitri and Jean-Luc Vila, 2009. "A Preferred-Habitat Model of the Term Structure of Interest Rates", NBER Working Papers 15487, National Bureau of Economic Research, Inc.