Preliminary Thoughts about the ECB and Corporate Bonds

The targeted long-term repo operations had not even been launched when the ECB announced its intention to buy asset-backed securities and covered bonds.  It then began to buy covered bonds before the conclusion of the Asset Quality Review and bank stress tests.

This insistence on putting the proverbial cart before the horse fosters an environment that lends itself to speculation of even more measures.  In addition, comments some official comments appear to express skepticism over the efficacy of current measures.  This is different from the well-known German objections, which are rooted not so much in efficacy as in the moral hazard issues. 

While reports that the ECB may add corporate bonds to its asset purchases have been played down, it may be hard to shake the general idea that the ECB is likely to do more than it has already announced.  Under one view, the ECB is acting like Churchill quipped about Americans (that they can be counted on doing the right thing after exhausting the alternatives).  Eventually, they say the ECB will exhaust the alternatives and adopt genuine quantitative easing.

This seems to be a rather harsh judgment.  It presupposes that quantitative easing is only about sovereign bonds.  To do so, it distorts the complex reality of the recent experience.  Two points are worth considering in this context.  First, the Federal Reserve did not call its Treasury and MBS purchases "quantitative easing" but rather "credit easing".  Second, the BOJ, who appears to have coined the phrase "quantitative easing" is currently engaged in buying a range of assets that include commercial paper, corporate bonds, ETFs and REITs.  The Swiss National Bank did not buy domestic bonds (too small of supply) and instead bought foreign bonds.

Nevertheless, many investors are skeptical that sufficient easing of monetary conditions is possible through the TLTRO and the ABS/covered bonds purchases.  This failure of the ECB to earn the credibility of investors leaves it in an unstable situation by not adequately anchoring expectations.

The largest pool of assets for the ECB to buy are government bonds.  There are around 6.5 trillion euros of euro-area government bonds.  About 5% of them (~332 bln euros) are currently being used for collateral purposes.  With 18 separate issuers, a sovereign bond purchase program has a number of technical challenges.  However, the legal and political obstacles are even more formidable. 

The problem is that the ECB is explicitly barred from debt financing.   It appears that the ECB can buy government bonds, in the secondary market provided it can do so without financing government debt.  Therein lies the rub.   Reasonable people can and do differ on interpreting what constitutes debt financing.  That said, BBK Weidmann has acknowledged there are certain conditions under which the ECB could buy government bonds. He has not specified what those conditions are.   

There are supra-national bonds that the ECB could buy.  The EFSF and ESM have issued about 230 bln euros of bonds.  In addition, there are around 60 bln euros of EU bonds and 200 bln euros of European Investment Bank bonds.    There does not appear to be large obstacles that prevent the ECB from including these in its asset purchase plans.  While the outstanding amounts are modest, they could help supplement the existing program.  

In a few days, the ECB will publish the results of the Asset Quality Review and the stress tests.  This will place it in a better position to buy bank bonds.  Covered bonds are one type of bank bond.  There are around 1.5 trillion euros of outstanding covered bonds.  A little more than a quarter are already being used for collateral.  There are nearly 2.3 trillion euros of bank  uncovered bank bonds, and about an eighth (~282 bln euros) are already being used for collateral purposes.   

Buying uncovered bank bonds seems like a more direct extension of the covered bond purchases than buying corporate bonds.  It could also help facilitate the de-leveraging of financial institutions, which is still desirable.  

The amount of eligible corporate bonds is a little less than half the size of the uncovered bank bonds.  The European corporate bond market is broadly about 1.5 trillion euros.  However, this includes non-EMU bonds and non-euro denominated issues.  When these are excluded, there is an estimated 900 bln euros to one trillion euros. 

As it is widely recognized, European corporates typically rely more on bank loans than marketable bonds to raise capital.  Corporate bond issuance is highly concentrated in a few countries.  The largest is France, which accounts for a little less than half of EMU corporate bonds (44%).  German and Italian corporates equally divide another quarter of the EMU market.  The Netherlands account for a little less than 10%.  Combined these four countries account for more than three-quarters of the euro area corporate bonds. 

There could be a wider impact that the concentration of issuers would suggest.  The displacement of current investors in EMU corporate bonds would encourage a shift in the composition of portfolios.  It could lower corporate funding costs..  Some observers suggest that it could boost corporate investment, but this seems to be unduly optimistic, if not naive.  Given the large cash holdings of European corporations, there is not lack of wherewithal.  The more significant restriction is the absence of profitable opportunities. 

We have suggested that the ECB could take a page from the Swiss National Bank's playbook.  It could say that it would likely to buy member bonds, but the legal and political hurdles are insurmountable.  Instead, it will buy foreign bonds, and for transparency, liquidity and safety, US Treasuries stand out.   

There has been a push back against this suggestion.  Some cite the G7 statement in February 2013 (section 3.2) reaffirms the commitment to market determined foreign exchange rates.  ECB buying Treasuries would violate that agreement as it would look and feel too much like intervention.   However, the recent commentary of ECB officials talking the euro lower would seem to suggest it already has a liberal interpretation of that edict.  

Moreover, the G7 statement simply called for close consultation with the other G7 partners.  This need not be an insurmountable hurdle.  Consulting does not have to mean approval is necessary, or that another G7 country can veto/overrule the ECB's conduct of monetary policy. 

Others resist such proposals because it does not address what they see as the key problem in the euro area.  This is the reluctance of the creditor countries, like Germany and the Netherlands from offsetting the necessary fiscal consolidation in the periphery with greater accommodation.   Driving the euro lower is a way to avoid the necessary internal adjustment process.    However, neoliberalism cannot simply be foisted onto the euro area. Arguably, the G7 have a vested interest in a stronger and more dynamic euro area.  Expanding the  balance sheet is one way that many other central banks have pursued at the zero-boundary.  

In summary, it seems clear that the ECB is considering other assets that it can buy. Corporate bonds are among the possibilities.  However, uncovered bank bonds seems to be a more logical extension of the current efforts (covered bond and ABS purchases), and the supra-nationals have little of the legal and technical baggage that is posed by sovereign bonds.  Moreover, corporate bonds are highly concentrated in a few countries, especially France.  Most likely it would not increase investment.  There is a certain logic to buying foreign bonds, such as Treasuries, but it has yet to find much traction.