Who will profit from Eurozone QE?

Finally, the European Central Bank is expected to launch its first programme of full-blown quantitative easing, buying sovereign bonds outright with freshly-printed euros. The announcement could come as soon as this Thursday’s policy meeting. But there are big questions still unanswered over how exactly to conduct QE in a currency union made up of supposedly independent countries and autonomous governments.

Most analysis has focused on the question of who will bear the balance sheet risk? Will the ECB buy and hold the bonds? Or will it instruct national central banks to buy the bonds of their respective governments, so keeping the credit risk isolated on their own balance sheets? In all likelihood, this is a false distinction. So long as the Eurocrats stand ready to bail out troubled governments or to let national central banks write off bad debts, the risk of default is ultimately borne by taxpayers or savers across the eurozone. The distinction only matters if a government default and exit from the currency union is a real option. With that in mind, will the ECB really want to pitch a QE programme at the national bank level as an effective way to isolate credit risk? If the ECB does go this route, we bet it will play down the risk of default and currency union exit. That undermines the idea of credit risk isolation, but it is better than undermining the whole currency union.

Why, then, would the ECB bother with conducting QE at the national level? Because QE is more likely to create profits than losses; and the periphery may not want to see a massive wealth transfer to Germany.

To understand this dynamic, consider the three ways that governments around the globe usually finance themselves:

this is the least popular method, as its political and economic costs are obvious and felt immediately.

on its own, government debt only transfers the burden to taxpayers tomorrow, and is thus only slightly more popular than taxes today. That is unless the government debt is bought by someone very special in the hearts of politicians, the central bank.

if the government’s debt is bought by the central bank, then all future interest and principal payments are remitted back to the government.

So, regardless whether the central bank buys the bonds on the primary or secondary market, this is effectively free money. Of course, there is no such thing as a free lunch. The free money is new money, so consumers and savers pay most of the bill through the debasement of the currency. This is the least unpopular way to finance governments, so long as the option is not overused. Many governments have decided to use this option as much as they can-so long as it does not cause inflation to rise materially above 2%, at which point it becomes too obvious and destructive. In normal times, central banks print just enough money and buy just enough government bonds to help banks meet their reserve requirements and to keep interest rates at the right level to encourage banks to extend just enough credit to create just enough inflation to help the government (without being too obvious about it). QE has

1. Taxation:

2. Borrowing:

3. Printing:

much the same results, but given its scale and direct nature, the effects on inflation and the benefits for government financing are that much clearer. During crises, “whatever it takes” is a much easier sell.

The US has just provided a remarkable example of the third option at work. Last year, the US Treasury paid a record amount of interest, roughly $430 bln. But over the same period, the Fed remitted almost $100 bln to the Treasury, thanks to a balance sheet bloated by QE operations. If we net out remittances from the Fed, the Treasury’s interest payments fall by almost a quarter. Or, to put it another way, with $17.6 trln in debt outstanding in 2014, this effectively lowered the Treasury’s interest cost by around -50bp. And that is before we factor in any effect on market rates.

But what about the eurozone, where many governments are involved? Normally, any profits made by the ECB are pooled and distributed to member countries in proportion to the central bank’s capital subscription weightings, which are based on population and gross domestic product. That means Germany gets the most, then France, and so on. In a QE programme today, most of the profits are not going to come from German or French bonds, which yield next to nothing. Most are going to come from the smaller peripheral governments that are currently paying more interest on their debt. We don’t need to do any math to figure out that

QE done by the ECB would result in a massive transfer of wealth from the periphery to Germany and France.

What would make a big difference is if the ECB made an exception to its normal profit-sharing practices, and said that all profits on Portuguese bonds will go back to the Portuguese government, all profits on Italian bonds go back to the Italian government, and so on. In this structure, all eurozone governments would benefit from QE, at the expense of anyone holding the currency (just as happened in the US, UK, Japan). The German government would also benefit from any central bank purchases of its debt, but it will no longer also receive a massive transfer of wealth from the periphery.

While everyone is talking about how Germany may demand that credit risk be isolated within each country, that may be a mirage. It may well be the peripheral governments that want the profits from QE to stay within each country-so they can reap all of the regular benefits of currency debasement.

What does this mean for markets? However it is structured, QE is likely to weigh on the currency (that is, if the ECB actually debases its currency on a scale that lives up to lofty expectations). A big QE announcement would also likely lift equity prices, at least initially.

What happens to bonds and spreads is more complicated, and very much dependent on the structure of the programme. Consider the two options:

1. QE is conducted on the ECB’s balance sheet, with risks and profits distributed as normal:

This will reemphasise policymakers’ commitment to the union; and so the likely first reaction will be for a further narrowing of spreads between the periphery and Germany. But this may be short-lived. For one thing, yields may rise across the board on greater inflation expectations stemming from the QE announcements (yields tended to rise, not fall, during US QE operations). Second, the market may wake up to the fact that peripheral governments are now going to be sending a lot of interest and principal payments to Germany and France, which could then cause spreads to widen.

2. QE is conducted at national level, with profits circulated back to the paying government and risks also kept at the national level:

Much will depend on how the ECB sells the structure. If the emphasis is on isolating credit risk, the first reaction will be for markets to question the shelf-life of the currency union itself all over again. Spreads will widen. More likely, however, the ECB will try to play down the isolation of credit risk, and will focus attention on the fact that this scenario will provide the most fiscal assistance to the governments that need it most. Of course, this violates the supposed principle that monetary policy in Europe is independent from fiscal policy-but the idea that a central bank could ever exist without having effects on fiscal policy is complete nonsense anyway.