- There are four options on the table for sovereign QE in the eurozone
- We expect the ECB to use its capital key and share credit risk
- The alternative option of keeping credit risk national could be negative for peripherals
QE is coming, but what shape will it take?
It has become increasingly clear over recent months that the ECB will embark on a large scale asset purchase programme, with sovereign bonds making up a significant element. However, the way in which the ECB will conduct its sovereign bond purchases is far from clear. Speeches by the ECB’s Chief Economist Peter Praet and Vice President Vitor Constancio have set out some possibilities. An article in yesterday’s Dutch financial daily (Het Financieele Dagblad) reported three options, citing ‘people familiar’ with the ECB’s discussions.
Four options on the table
From the sources above, we distinguish four potential options for sovereign QE. The first option is to buy the sovereign bonds of all eurozone member states using the ECB’s capital key. The second option is to buy member states’ bonds on the basis of outstanding debt. The third option is that national central banks buy their own country bonds (again on the basis of the capital key or outstanding debt) but at their own risk. The final option is to buy only AAA bonds (essentially Germany, Finland, the Netherlands and the Austria for all practical purposes).
Our base case is the capital key with shared risk
Our central scenario is that the ECB will choose the first option. The capital key is the natural way to distribute purchases between countries. Such an approach would mean that the ECB would buy relatively more debt of countries with lower outstanding amounts of government bonds relative to GDP. The chart on the right shows the outcome in a stylised example assuming a EUR 525bn programme. We also assume that the central bank focuses on longer maturities given very low (and negative in some cases) yields on the short end. There would probably be a maximum proportion it would buy of any one country (for instance 30%). Please see our note (‘Sovereign QE: Winners and Losers’, Euro Rates Weekly, 24 November 2014) for more on this issue.
The second option of using outstanding debt would equalise the proportions of bonds bought of the various countries, meaning countries with high outstanding debt would no longer be penalised compared to the capital key option.
Keeping credit risk national could be negative
The third alternative of having national central banks buying their own country bonds at their own risk would be the least effective version of QE in our view. There are various ways of central banks picking up the risk but the government in each country would be the ultimate bearer of the credit risk. Taken to the extreme, this can be seen as each country being the guarantor of their own debt in case of their own default, which is more than a little absurd. Depending on the exact details, such a programme could increase sovereign risk, and could actually be bad news for peripheral bonds.
The final option of the ECB only focusing purchases on AAA bonds could also weigh on peripheral bonds. However, they will benefit from the portfolio re-balancing effect so disappointment could be short-lived. A big disadvantage of this option is that it limits the potential universe of purchases, especially assuming that the ECB would stick to longer maturities given that it would not want to buy bonds that have a negative yield. The advantage is that it circumvents the ‘Greek issue’ which could be a delaying factor for the other options.