The monetary policy actions unveiled by Draghi on 4 September – a 10bp cut to all policy rates, the announcement of a private sector asset purchase programme and an aim to return the ECB’s balance sheet “towards the dimensions it used to have at the beginning of 2012" – were greeted with plaudits by many. And market reaction, at first at least, was favourable, with the euro falling and inflation expectations rising. But, with the tools at its disposal, will the ECB be able to boost the ECB’s balance sheet to its early-2012 level of €2.7-3trn? And even if it can, will that be sufficient to ward off risks of stagnation (and deflation) in the euro area?
Draghi’s comments implied that the ECB would like to boost its balance sheet by €0.7-1tn. Is that plausible? In the near term, the answer is almost certainly no. With the big bazooka of QE (of the sovereign bond purchasing-type) having been locked in the cupboard marked “for use in dire emergencies only” (the German translation probably reads “when hell freezes over”) the Governing Council has left itself with the uphill task of trying to buy a sizeable amount of ABS and covered bonds. And this is a task made all the harder by the introduction of an even deeper negative deposit rate, which provides some holders of these assets with a disincentive to sell their holdings for fear of being left with cash yielding a negative return.
The ECB’s seeming reluctance to set a target for these purchases – Board member Constâncio suggested last week that it will not announce a target when it reveals the technical details of the programme on 2 October – no doubt reflects its own doubts about its ability to deliver a sizeable purchase programme. We estimate that there are between €750bn and €1.1trn of eligible covered bonds left in the market, and around €300bn of ABS. At first glance, therefore, potential supply of such securities may not be a problem. However, unless the ECB’s presence in the market prompts an enormous and rapid surge in issuance, their actual supply is likely to be significantly smaller. The ECB’s last covered bond purchase programme failed to buy even €40bn in 2012 due to investors’ rising demand and a decline in supply (see table). Two years on, with the covered bond market now smaller, it is difficult to see why the ECB would have more success in buying significant amounts of covered bonds. For similar reasons, current ABS holders may also prefer not to sell.
For now, therefore, it’s anyone’s guess how many of these assets, and over what timeframe, the ECB will be able to purchase. Our best guess is that, over the next couple of years, the ECB’s asset holdings could rise from the current level of €200bn (three quarters of which is the SMP portfolio of peripheral government bonds) to around €400bn after factoring in the ECB’s maturing current asset holdings, an increase of only 2% of GDP.
So, assuming an asset purchase programme with a gross size of €300bn, the bulk of the increase is going to have come via additional liquidity. But, forcing extra funds into the system is not going to be easy this time around – as well as representing a potential constraint on the ECB’s asset purchases, the negative deposit rate will certainly make many banks reluctant to hold a significant amount of excess liquidity. As the chart below shows, the Eurosystem’s assets have shrunk since 2012 mainly as a result of repayment of LTRO funds, which now stand at just at €350bn (from a peak of almost €1tn). That remainder is due for repayment by March 2015.
The allotment of funds from the first TLTRO tender will be announced tomorrow (see our full TLTRO assessment here). Appetite for fresh liquidity seems unlikely to be large. That is certainly true for the largest potential beneficiaries (banks in Germany and France) which have paid back all but about €50bn of LTRO lending and which might see little reason to take on extra liquidity in the coming months. Even if other countries’ banks fully draw on their TLTRO allowance – which in any case seems more likely to occur at the second tender in December, when some will look to refinance their LTRO borrowings before they mature – we doubt that this year’s two tenders will allocate much more than a combined total of €200bn. If we’re right, this would imply a net contraction of long-term liquidity by €150bn between now and March 2015, and a corresponding shrinkage in the size of the ECB’s balance sheet.
So, achieving the aim of returning the balance sheet to early-2012 levels is going to be a big ask for the ECB. We, frankly, doubt that it is achievable. But even if it is, would it be enough to lift a moribund, disinflating economy? Again, that has to be doubted. The increase in the balance sheet implied by a return to €3tn is 10% of GDP. So, assuming that half of that increase is the result of liquidity provision, the increase in asset purchases would equate to around 5% of GDP. Compare that with QE elsewhere in the G7 (see table). The BoJ is on track to take its asset purchases since the GFC to 42% of GDP by the end of 2015, while the Fed and the BoE have both bought around 25% of GDP, and implemented against a backdrop of much higher headline inflation. The ECB’s efforts, on the other hand, look puny, leaving it firmly at the bottom of the table.
Ultimately, therefore, Draghi’s announcement earlier this month is likely to prove a disappointment, both in its size and its impact on the economy. Indeed, his talk of an “aim” rather than a “target” for balance sheet expansion reminds us of the pre-Kuroda BoJ, where inflation was always a mere ambition on the grounds that what would be required to achieve a target – massive QE – was unpalatable. The same seemingly applies to the ECB – it may well be right that credit easing is, pound for pound, more effective than QE via government bond markets, particularly when interest rates are already so low. But if the nature of credit markets means that a large-scale asset purchase programme is not possible, then its impact is going to be very limited. History teaches us that meaningful QE can only really be done via government bond markets (or in the case of the US, via a combination of government bonds and a large, liquid, MBS market). With the hurdle for proper QE now seemingly set very high by the ECB, the risks to the economy, including the risk of slide into deflation, remain sizeable.
Eurosystem balance sheet: Assets
Source: Datastream, ECB and Daiwa Capital Markets Europe Ltd.
Euro area: LTRO holdings and TLTRO allowances
Source: Datastream, Bloomberg and Daiwa Capital Markets Europe Ltd.
League table of major asset purchase programmes
Source: National sources and Daiwa Capital Markets Europe Ltd.