Central banks buying bonds can lead to unintended consequences
What if the Reserve Bank bought the bonds of Eskom, Edcon or any sickly company you can think of?
It’s not as crazy as it sounds, considering none other than the mighty European Central Bank (ECB) once found itself as a proud owner of bonds issued by Steinhoff. That company, if anyone needs reminding, is now best known for perpetrating SA’s biggest corporate fraud yet.
The ECB bought Steinhoff bonds after it expanded its asset purchase programme to include corporate debt. Then, in December 2017, the company said it had found “accounting irregularities”, leading to a collapse in the price of its shares and bonds. The central bank, facing the real possibility of being a Steinhoff shareholder and being part of mercy bankruptcy proceedings in the face of its collapse, got rid of its stake in January 2018.
Reuters reported at the time that the ECB, which didn’t disclose the value of purchases and sales, probably lost more than half what it had paid for the debt. A few months later it said it had set aside €69m to cover losses on a corporate bond.
Due to the Covid-19 outbreak and the need to rescue the economy and state-owned enterprises through any means necessary, the debate about quantitative easing (QE) is back in the headlines.
Not that the Bank has shown any interest in playing ball. If it had cut interest rates to less than zero and undertaken the sort of government bond buying required, it would be a matter of time before it was expected to expand its “development role” and go further, acquiring all sorts of corporate and stateowned enterprise (SOE) instruments.
Surprisingly, the most interesting thing I read about QE (money printing by central banks to buy financial instruments in the hope of suppressing the cost of credit and to boost demand) last week wasn’t published in SA. I stumbled upon an article by a former colleague from Bloomberg who now writes for the Luxembourg Times.
It concerns the purchase by the ECB of bonds issued by CPI Property Group, a company accused by Luxembourg’s financial regulator of having illegally stripped off its most prominent assets from their legal owners. The bonds were bought as part of the ECB’s €750bn buying programme.
The Luxembourg Times quoted media in the Czech Republic, where the company’s owner lives, saying the ECB bought €112m, or 15%, of the whole issuance.
The issue is also likely to rear its head in the US where the
Federal Reserve has entered uncharted territory by buying non-investment grade paper as part of its QE programme, leading, according to the Financial Times, to a surge of company junk-bonds issuances in April of $32bn (R561bn).
The Fed’s rationale for participating in the high-risk part of the market is not too different from the Reserve Bank’s decision to buy junkrated sovereign bonds here at home. There is one difference in that the Bank’s programme, which is restricted to government bonds, is less generous and specifically doesn’t aim to influence prices.
If anything, there is a possibility that we might in the next week find that the local central bank has pared back its activity, which might be a sign that it feels it has succeeded in its aim of stabilising markets.
Due to renewed debate about the use of private and public pensions to rescue Eskom and the need for the Bank to play a “developmental role”, the issue is far from decided. While the European and US examples show the dangers that wide-scale intervention by central banks entail, much of the debate in SA treats such money in the hands of the Reserve Bank as “monopoly money” with no thought about who will eventually foot the bill.
In the ECB example, Steinhoff and CPI are small relative to the €750bn asset purchase programme. Losses by the Fed will also be tiny, even if a substantial number of the junk bonds it buys end up being worthless.
But it raises uncomfortable questions about moral hazards and the central bank being used to rescue companies that took on risky bets, were mismanaged or had business models that are no longer viable in the post-Covid world.
In this context, it is worrying that the Public Investment Corporation, a custodian of public sector workers’ pensions, is seriously considering exchanging about R90bn of Eskom bonds — which still provide a regular income as it hasn’t defaulted — for shares that would be of no value to the beneficiaries of the Government Employees Pension Fund (GEPF).
As with potential losses if the Bank expanded its acquisition of junk-rated government bonds, the assumption that informs much of the debate about pensioners rescuing Eskom is that this would be a cost-free exercise.
But how can that be if one assumes that bonds are rated junk for a reason and that investors expect their value to drop?
As the GEPF operates on a defined benefit basis, workers’ money is theoretically safe because the government will foot the bill if needed.
And if the government itself is bankrupt, no problem because you can get the central bank to print more cash.
The problem is that it’s hard to see a scenario in which this doesn’t end up with workers holding money that’s not worth the paper it’s printed on.