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ECB equity purchases: too risky, really?

Instead of buying sovereign debt, the ECB could broaden further its purchases to include equity of all sorts. Fuelling an equity bubble is no worse than fuelling a bond one. It can be mitigated by intervening secretly and including non listed securities. Inhibitions to take risk should be lifted.
By Urszula Szczerbowicz, Natacha Valla
 Post, January 9, 2015

Given negative surprises in inflation outturns and the limited ability of the ECB to expand its balance sheet with existing measures, the ECB is now expected to expand its asset purchase programme and commit, as early as January, to also purchase sovereign bonds. Reports have even spelled out the three main avenues the ECB might consider to implement such purchases (by the ECB itself proportionally to Member States’ key in the ECB capital; or by the National Central Banks so as to decentralize potential losses; or to restrict purchases to high quality AAA instruments).

Are sovereign purchases the right thing to do for the ECB at the current juncture? Many economists believe not! Problems associated with bond purchases by the ECB are well known. Nominal and real interest rates are already very low. The yield curve is exceptionally flat, so their impact would be at best minimal. And fiddling with sovereign debt is a tricky thing. In fact, to avoid them, the ECB has contemplated – and even started in some cases  purchasing alternative asset classes (such as ABS, covered bonds, and perhaps soon also corporate debt instruments).

But there is another asset class the ECB could buy. That is equity. Equity is everywhere. Listed equity markets are liquid in all major currencies. They cover a wealth of sectors. Unlike debt instruments, equity cannot default. And equity exists in many forms: plain vanilla, listed, non-listed, private, etc. Yet, the ECB seems to snob them altogether. But in the desperate search for ways to conduct monetary policy through quantities, have equity purchases not become the elephant in the room for the ECB?

The idea that central banks could purchase risky assets for monetary policy purposes is very old. In many places, it is no taboo any more. The Bank of Japan (BoJ), Bank of Israel, the Swiss National Bank and the Czech National Bank  among others – all have recently increased their equity holdings, sometimes significantly. Most, but not all, have done so to diversify their reserve portfolios. Looking further back in history, there are good examples of equity market interventions that went beyond reserve management. Hong-Kong and Japan are two examples at hand. In October 1998, Hong Kong was – and still is – in a currency board. The Hong Kong Monetary Authority (HKMA) had to fight speculators who were simultaneously selling the local currency and shorting the Hong Kong stocks. Had the Authority sticked to a “standard” interest rate hike to defend the currency, stock markets would have fallen, making speculative short-selling very profitable. However, HKMA managed to squeeze speculators by directly purchasing the stocks using reserves in order to increase their price. As a result, equity purchases allowed the HKMA to foil the self-fulfilling speculative attack and support the economy without having to give up its primary objective of exchange-rate target.

Japan is a second example. Between October 2002 and September 2003, The BoJ also conducted outright purchases of stocks. Their objective was different. In the early 2000s, the Japanese banking sector, undercapitalized and struggling with non-performing loans, was weakened even further by the sudden decline of the Nikkei. Indeed, market risk associated with equity holdings weighed significantly on the balance sheets of major Japanese banks. With a view to mitigate that risk, the BoJ decided to purchase directly the corporate stocks held by financial institutions.

At first sight, the ECB does not share the same issues as HKMA or the BoJ at the time. There is no generalized short selling in euro area equity markets (but those things change fast). And it is not clear that the market risk associated with equity holdings is the most pressing issue for euro area banks.

Yet, equity purchases by the central bank can serve monetary policy purposes in other ways. They can channel central bank money to economic sectors where it is missing. They can put the central bank in a position to act as a long term risk taker to sustain long term growth. They can affect the quantity of money that circulates in the economy without fiddling too much with the banking sector. Accessorily, they could also affect the exchange rate if conducted in foreign currencies. They are also less distortive than bond purchases if debt is more mispriced than equity. And last but not least, they keep the central bank’s fingers away from the sovereign. Those purposes seem to match ECB preferences fairly well.

What would happen if the ECB changed course and purchased corporate equity instead, or on top of, sovereign bonds? Volatility would probably go up (but that might happen anyway). Equity markets would rally. This might not be such a good thing given the high level of equity valuation prevailing at the time the ECB envisages QE. But under current circumstances, it might not be worse to fuel an equity (Charybde) rather than a bond bubble (Scylla). And there are ways to minimize this price distortion. The ECB could select sectors where valuation underperforms the market. They could target areas of the real economy where financing is missing. They should not even feel constrained to stick to plain vanilla, listed markets. And the price impact of equity purchases can be mitigated by intervening secretly or with loose communication.

Equity purchases – in the broad sense - are an option for the ECB to reflate the euro area economy. So why has the ECB been so reluctant to investigate it further? One reason could be their riskiness. But this argument is not reasonable. Debt is risky too, especially in the current context where yields are extremely low, the value of fixed-income securities likely to decline, and the solvency of debt issuers - sovereign and corporate - sometimes put into question. Another reason could be the violation of equal treatment, as specific equity purchases would by nature favour a sector or a country. But that level playing field argument is not specific to equity either. Bond purchases, sovereign or corporate, are subject to the same caveats.

There might well be other valid options on the table for the ECB to usefully expand its balance sheet – such as directly financing the EIB and the Juncker Plan, or handing over cash to the public at large. But either way, it is time the ECB removed inhibitions about taking risk.
Money & Finance  | Europe 
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