ECB risks undermining QE if it opts for compromise plan
The ECB is considering three main options for pumping money into the struggling euro zone economy but two of them could hurt confidence in the bloc's most indebted states, defeating the object of the exercise.
With euro zone consumer prices falling in December, for financial markets it's no longer a question of whether the European Central Bank will act to boost economic growth and ward off a deflationary spiral, but when.
President Mario Draghi may announce an ECB program of buying government bonds, using newly printed money intended to flood the wider economy, as soon as the Governing Council's next policy meeting on Jan. 22.
The main scenario for markets is that the ECB will join its U.S., Japanese and British peers in launching quantitative easing (QE) by buying government bonds in amounts proportionate to each euro zone state's shareholding in the bank.
But objections from the Germany's Bundesbank to the ECB taking on sovereign credit risk have raised two compromise solutions, as suggested by recent comments from ECB chief economist Peter Praet.
Option two is that national central banks buy the debt of their own governments, so the risk remains with the country in question. The third is the ECB buys only triple-A rated bonds, hoping that investors would turn to the lower-rated debt of weaker euro zone government which, while riskier, offers a better return.
However, economists believe the second and third options could backfire. If the ECB were unwilling to take on the risk of holding Greek, Italian, Spanish or Portuguese debt, private investors might ask themselves why they should do it.
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The main scenario preferred by investors appears most in keeping with the solidarity principles of European monetary union. If the ECB had to take losses on the bonds of a member state which could not repay its debt, the central bank would have to be recapitalized by all 19 euro zone governments.
Private investors would also suffer losses in any debt write-off but at least the pain would be shared. By contrast, options two and three would not spread risk across the union; investors could therefore seek a premium on lower-rated bonds, pushing up yields for the governments of the very countries that need lower borrowing costs most.
"It seems like a step away from the whole notion of monetary union," said Luke Bartholomew, investment manager at Aberdeen Asset Management, a firm with over 400 billion euros of assets.
"Secondly, it is a pretty explicit acknowledgement of the credit risk that the ECB doesn't want to have on the balance sheet and that is a signal that they don't want to send."
Compromise
Government borrowing costs set the standard for the interest rates that businesses and consumers pay for funds, and QE aims to deliver an economic boost by bringing them down. But under options two and three, they might even rise in the euro zone's "peripheral" economies which are struggling to grow and suffering from high unemployment.
"If central banks cannot agree on risk sharing and they are reminding the market of the risk, then it's not getting the same bang for the buck in terms of how much sentiment improves as they would get with the first option," said Michael Krautzberger, head of European bonds at BlackRock, the world's largest money manager.
Krautzberger said he would have a "less constructive" attitude to peripheral bonds if the ECB rejected the main scenario. He said he would prefer that the ECB compromised on the size of the program rather than dropping this option.
Option three is seen as the worst, one which some investors believe might even lead to a sell-off in peripheral bonds.
The potential size of the program is limited from the start. RBS calculations show triple-A rated debt amounts to 3.3 trillion euros of the 7 trillion euro zone market.
In the euro zone, Germany alone still has the top rating from all credit agencies although Austria, Finland, Luxemburg and the Netherlands have a triple-A rating from at least one agency. France is now top rated by only the small DBRS agency, but this should be enough for the ECB to buy its debt.
About half the top-rated bonds already offer yields of less than 10 basis points or even negative returns, so it is unlikely that they would fall much further, limiting the market impact per euro printed by the ECB.
Draghi's promise
However, RBS senior European economist Richard Barwell said markets might accept a compromise that falls short of the main scenario, provided the ECB could make clear that limits to the size and scope of purchases were not permanent.
But the ECB's reluctance to take on peripheral debt could be seen as breaking Draghi's promise at the height of the euro zone crisis in 2012 to do whatever it takes to save the common currency.
"It depends if you think it is the end of the road," said Darren Williams, European economist at AllianceBernstein. "The experience of the past couple of years shows ... that if the ECB needs to do more, then it will do more."