The German constitutional court examining the legality of the PSPP (see here) did not find ‘a violation of the prohibition of monetary financing of Member State budgets’. However, it did cast doubt on the European Court of Justice’s judgement that the PSPP satisfied ‘the principle of proportionality’, saying that is ‘not comprehensible’. This seems to relate to whether the benefits of the programme justified the negative effects. It therefore concluded that ‘following a transitional period of no more than three months allowing for the necessary coordination with the Eurosystem, the Bundesbank may thus no longer participate in the implementation and execution of the ECB decisions at issue, unless the ECB Governing Council adopts a new decision that demonstrates in a comprehensible and substantiated manner that the monetary policy objectives pursued by the PSPP are not disproportionate to the economic and fiscal policy effects resulting from the programme. On the same condition, the Bundesbank must ensure that the bonds already purchased and held in its portfolio are sold based on a – possibly long-term – strategy coordinated with the Eurosystem’.
The court stressed that ‘the decision published today does not concern any financial assistance measures taken by the European Union or the ECB in the context of the current coronavirus crisis’ meaning that this judgement does not hold for the PEPP, which is by far the most significant programme in terms of the current pace of net asset purchases. Indeed, year-to-date, the Bundesbank has only bought a net EUR 6bn of assets under the PSPP.
Having said that, if the ECB is unable to prove that its decisions were ‘proportionate’, the Bundesbank would over time need to sell/run-off the assets held under the PSPP, which amount to EUR 534bn. Needless to say that is a big deal. Theoretically, the ECB/another national central bank could step in to purchase the target for German public sector assets or even the stock, though that is complicated as there is no risk sharing when it comes to government bond purchases. If the ECB is unable to prove its decisions were proportionate, this could put significant upward pressure on Bund yields and hence also on EGB yields more generally. This would tighten financial conditions and put more pressure on the PEPP to be aggressively expanded to offset this.
However, it is important to note that the PEPP may not be untouchable. A potential risk is that in future the PEPP could be seen as violating the prohibition of monetary financing. For the PSPP, the issue(r) limits, and the limitation of the volume of the programme were key factors in the judgement that it did violate this principle, while the PEPP is not constrained by limits. This raises the risk in future that the Bundesbank’s participation in the PEPP could also come under threat. This seems to be a tail risk at this stage. Nevertheless, it could damage the credibility of the ECB’s current ‘whatever it takes’ approach.
All this means that a lot hangs in the near term on whether the ECB is able to demonstrate that its actions have been proportionate. Certainly, the ECB has produced a body of research showing the positive effects of assets purchases on growth and inflation. These estimates suggest that the eurozone may have entered a deflationary spiral had it not launched the PSPP in 2015. So our sense is the most likely scenario is that the ECB will be able demonstrate that its actions were proportionate.