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No sweat

2 December 2014 By Neil Unmack

The European Central Bank need not sweat over its sovereign debt. Critics say ECB sovereign bond-buying could expose the central bank to risky countries, a form of fiscal transfer. The argument is good on paper. But based on the ECB’s target, the peripheral exposure could be lower than in 2013.

Europe’s economic stagnation undermines two criticisms of quantitative easing: that it causes inflation, and relieves the pressure on governments to reform. Dismissing the third criticism, the risk of losses, is harder, because one can only guess at how much debt the ECB will buy. The central bank wants to get its balance sheet to 3 trillion euros, or a 1 trillion euro increase over its current size. However, since old liquidity injections and asset purchases are maturing, it will need to expand by up to 1.5 trillion euros.

The goal is to hit the target through four-year loans and purchases of covered bonds or asset-backed securities. But it now looks likely that corporate and government bonds will need to be acquired as well. Assume a total take-up of 700 billion euros for the four-year loans, as estimated by RBC economists. Then bond purchases – public and private – would total at most 800 billion euros.

Working out how much of that will be government bonds requires more guesswork. The ECB can buy from a 1.6 trillion euro pool of covered bonds, asset-backed debt, and high-quality corporate bonds. Assume those purchases are capped at a fifth of the total market, in order to avoid price distortion. That would mean acquiring 480 billion euros of government debt.

That sounds like a lot when compared with the ECB’s 95 billion euros of capital and reserves. Yet the risk would be smaller than it appears, because purchases will follow the ECB’s ownership key. Debt issued by Europe’s most indebted nations Greece, Italy, and Portugal would amount to 14, 84 and 12 billion euros respectively – less than the amount bought during the 2010-2012 crisis. For example, in February 2013 the ECB held 102 billion euros of Italian bonds. Those bonds are now maturing, so the bank’s exposure might not increase much.

Those numbers should soothe sovereign QE worrywarts. Unfortunately, they also suggest the impact may be more limited for weaker economies, where low inflation and high sovereign risk premia have pushed up the real cost of debt. As ever, monetary policy in the euro area stems from compromise.


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