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Purchases of sovereign bonds: the ECB confronted with the heterogeneity of the Euro area

The ECB has confirmed its determination to counter the risk of deflation in the eurozone by evoking the possibility of sovereign bond purchases, but is confronted once again with the heterogeneity of the area. The need for compromise could jeopardize the effectiveness of its action.
By Urszula Szczerbowicz
 Post, December 4, 2014

Recent communications of the European Central Bank (ECB) leaders confirm their willingness to fight the deflation risk in the euro area. On 21 November, the ECB President Mario Draghi said that the ECB would do what it must to raise inflation and inflation expectations as fast as possible. On November 26, the Vice-President of the ECB, Vítor Constâncio, mentioned the possibility of Euro area sovereign bond purchases as a means to achieve this goal.

Sovereign bonds purchase program expected in 2015 seems very different from the two previous programs –SMP (Securities Markets Programme) and OMT (Outright Monetary Transactions)– aimed at limiting the financial fragmentation in the euro area. Since the announcement of the OMT in 2012 financial fragmentation has considerably declined and sovereign spreads between member countries are no longer a threat to the euro area stability. The objective of the sovereign bonds purchases this time is to bring down the overall level of long term rates in order to stimulate investment and consumption in the euro area and thereby increase inflationary pressures.

It has been pointed out that the long term rates in the Euro area are already at historically low levels. However, in order to judge the adequacy of the borrowing rates, it is important to compare them to the marginal net rate of return on capital ("natural rate" in the theoretical framework of the Swedish economist Knut Wicksell). When profitable investment opportunities are rare and businesses incurred important losses, the rate of return on capital can be negative. In this context, even very low borrowing rates are still too high and discourage investment. Thus, the ECB sovereign bond purchases, if they succeed in lowering the long-term borrowing rates, would be beneficial for the economy and might decrease the risk of secular stagnation.

According to this view the ECB should buy bonds of peripheral countries in which the differences between the borrowing rate and the return on capital are the highest. However, this policy seems difficult to implement as the core countries are against asymmetric monetary support in favour of countries in difficulty. This reluctance stems from the fact that the credit risk linked to the ECB sovereign bonds purchases would be borne by all member countries proportionally to their subscription to the ECB’s capital. Therefore, Vítor Constâncio hinted that the purchases could be conducted in proportion to the Member States’ capital keys at the central bank, which are based on a country’s contribution to the region’s gross domestic product. This would reserve the most important place for the purchases of the German, French and Italian bonds and subsequently lower long term interest rates in these countries.

The ECB monetary policy should however take into account the disparate macroeconomic conditions in the eurozone countries. It should be more accommodative in the periphery and tighter in countries like France or Germany. Conducting the opposite policy could have damaging consequences: excessive inflation and asset bubbles could appear in the core countries, while investment would be discouraged in the periphery. The fragmentation of the Euro area would then be increased.

Despite this question mark, the program of sovereign bond purchases seems to be the only way for the ECB to reach its goal of price stability. The fact that the ECB considers it in such a complicated European context demonstrates its determination to counter the deflation risk and strengthens its credibility. This signalling effect of the recent ECB leaders’ communications could in itself encourage inflation expectations.


Figure 1 : Monetary and Financial Institution (MFIs) Loans to Euro area residents, ratios in % of the size of assets

Loans (total)

Loans to MFIs

Loans to Households and Non-Profit Institutions Serving Households, Lending For House Purchase

Loans to Non-Financial Corporations

Figure 2 : Securities Other Than Shares Issued by Euro Area Residents, ratios in % of the size of assets

Assets (total)
Assets issued by MFIs

Assets issued by General Governements

Assets issued by private non-financial sector


Source : Thomson Reuters Datastream.

References :

Acharya, Viral V & Steffen, Sascha, 2013. "The Greatest Carry Trade Ever? Understanding Eurozone Bank Risks", CEPR Discussion Papers 9432, C.E.P.R. Discussion Papers.

Becker, Bo & Victoria Ivashina, 2014. Financial repression in the European sovereign debt crisis. Available at SSRN 2429767.

Thomas Grjebine, Urszula Szczerbowicz & Fabien Tripier , 2014. "Corporate Debt Structure and Economic Recoveries," CEPII Working Paper 2014- 19 , November 2014 , CEPII.
Money & Finance  | Europe  | Economic Policy 
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