Who will profit from Eu­ro­zone QE?

Financial Mirror (Cyprus) - - FRONT PAGE - Mar­cuard’s Mar­ket up­date by GaveKal Drago­nomics

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.

Newspapers in English

Newspapers from Cyprus

© PressReader. All rights reserved.