Chapter

Chapter 6. An Early Assessment of Quantitative Easing

Author(s):
Petya Koeva Brooks, and Mahmood Pradhan
Published Date:
October 2015
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Author(s)
S. Pelin Berkmen and Andreas (Andy) Jobst 

The European Central Bank (ECB) has taken a series of easing steps since mid-2014, including a negative deposit facility rate and targeted longer-term refinancing operations to support new lending. In September 2014 the ECB announced a private asset purchase program comprising asset-backed securities and covered bonds and began purchases in the fourth quarter of 2014 to directly lower private borrowing costs. While private asset purchases have had a significant price impact, they fell short of reversing the contraction of the ECB’s balance sheet and the trend decline in inflation expectations.

In January 2015 the ECB announced the addition of sovereign assets to its asset purchase programs (Annex 6.1). The expanded asset purchase program is effectively open-ended and is larger than expected (i.e., purchases are intended to be carried out until end-September 2016, and will in any case be conducted until the ECB sees a sustained adjustment in the path of inflation consistent with its objective). The scale of additional sovereign asset purchases (about €840 billion in market value terms)1 under the public sector asset purchase program (PSPP) signaled a substantial expansion of the ECB’s balance sheet. This underscored the ECB’s commitment to meet its price stability mandate and helped anchor inflation expectations. Since the start of sovereign quantitative easing (QE)2 in March 2015, the ECB has expanded its balance sheet by 18 percent (as of end July 2015). Combined purchases of public sector securities, covered bonds, and asset-backed securities under the asset purchase program amount to €324 billion, with the split heavily skewed toward sovereign assets (€216 billion).

The ECB also took steps to strengthen transparency and communications. Starting in 2014 it extended its staff projection horizon by one year to better guide market expectations and began publishing accounts of monetary policy meetings. This, with the ECB’s regular press conferences after monetary policy meetings, has increased transparency regarding the Governing Council’s view. In March 2015, the Governing Council clarified its intention to continue the purchases until it sees a sustained adjustment in the path of inflation and at least until September 2016; and to concentrate on trends in inflation, looking through transient factors that do not affect the medium-term inflation outlook. In June the Governing Council reiterated the importance of fully implementing QE and was unanimous in its intent to “look through” the recent bond market volatility, unless financial conditions endanger medium-term price stability.

This chapter assesses the effectiveness and implementation of quantitative easing to date. It explores the various transmission channels and their impact on macrofinancial conditions and examines the design and implementation of asset purchases and their influence on the effectiveness of QE. The chapter concludes with policy recommendations.

QE’s Transmission Channels and Initial Assessment

The ECB’s QE had an immediate impact on financial conditions and expectations (Figure 6.1 and Figure 6.2). The initial market impact was stronger and broader than expected, lower term spreads across the euro area (portfolio rebalancing and signaling channels), with higher inflation expectations (expectations channel), a weaker euro (exchange rate channel), higher equity prices (asset price channel), an improvement in consumer and business confidence (broader confidence channel), and easier lending conditions (credit channel) (Figure 6.3). While the surge in bond market volatility since April 21, 2015, has unwound some earlier gains in asset prices, financial conditions are still easier than before (Kapetanios and others 2012).

Figure 6.1Monitoring the Aggregate Effect of Sovereign QE on the Financial Sector, as of July 13, 2015

Sources: Bloomberg, L.P.; and IMF staff calculations.

Note: QE = quantitative easing.

1Indicator variables are normalized between August 22, 2013, and August 21, 2014 (Jackson Hole speech). The sign of the unit of measure (standard deviations) is reversed in cases where a negative change in the indicator implies a positive economic effect. Thus, the greater the area covered by the spidergram, the larger the positive changes in indicators relative to their changes in the past.

2Indicator variables are normalized between August 22, 2014, and January 22, 2015 (Announcement of QE). The sign of the unit of measure (standard deviations) is reversed in cases where a negative change in the indicator implies a positive economic effect. Thus, the greater the area covered by the spidergram, the larger the positive changes in indicators relative to their changes in the past.

Figure 6.2Composite Aggregate Effect of Sovereign QE

Sources: Bloomberg; and IMF staff calculations.

1Indicator variables are normalized between January 1, 2007 and August 21, 2014 (prior to ECB President Draghi’s Jackson Hole speech). The sign of the unit of measure (standard deviations) is reversed in cases where a negative change in the indicator implies a positive economic effect. The composite measure (black line) indicates the simple sum of all individual indicator variables. The higher the values of the indicator variables, the larger their changes during the observation period relative to their changes in the past.

Figure 6.3Monitoring Sovereign Quantitative Easing—Scale of Purchases and Liquidity Conditions

Sources: Bloomberg, L.P.; Eurostat; ICAP; Markit; and IMF staff calculations.

Note: ABSPP = asset-backed securities purchase program; APP = asset purchase program; B/S = balance sheet; CBPP = covered bond purchase program; ECB = European Central Bank; EONIA = Euro OverNight Index Average; LTRO = Long-Term Refinancing Operation; MLF = margin lending facility; MP = monetary policy; MRO = main refinancing operations; PSPP = public sector purchase program; QE = quantitative easing; SMP = securities market program; TLTRO = targeted longer-term refinancing operations. Data labels in panel 6 use International Organization for Standardization (ISO) country codes.

1Securities held for monetary policy purposes (SMP, CBPPs, ABSPP, and PSPP).

2Securities held for monetary policy purposes (without SMP and other CBPPs).

3Excess liquidity = current account + overnight deposits – minimum reserve requirement – MLF.

The full impact on the real economy will take time to materialize. International experience with QE suggests that peak effects on growth could take between two to eight quarters, and from three to 16 quarters for inflation (IMF 2013a and 2013b). Engen, Laubach, and Reifschneider (2015) estimate that the response of unemployment and inflation to the Federal Reserve’s QE policies since early 2009 is expected to peak only in 2015 and 2016, respectively. In particular, as the IMF’s April 2015 Global Financial Stability Report noted, a credit recovery typically takes more time, especially if banks’ asset quality is still weak.

Portfolio Rebalancing and Signaling

Despite recent market corrections, term spreads remain low in selected countries—including Ireland, Italy, Portugal, and Spain—and in the euro area as a whole. Term spreads in core countries, however, have reverted to near their levels since the ECB announced its private asset purchase program in September 2014. Initial declines were sizable across the board (Figure 6.4), particularly given already low yields (relative to those of the United States and United Kingdom government bonds) (Banarjee 2012; Glick and Leduc 2013) (Figure 6.5). Given the price cap on negative rates, purchases initially focused on the longer end,3 which strengthened the decline in term spreads. This decline reflected a combination of factors, including expected short-term interest rates (signaling) and term premiums (as a result of both the duration and scarcity effects, given the long maturity of purchases).

Figure 6.4Change in Term Spread

(Basis points)

Sources: Bloomberg, L.P.; and IMF staff calculations.

Note: AAA = euro area countries with triple-A credit ratings; EA = euro area; QE = quantitative easing.

Figure 6.5Sovereign Yield Curves

(Percent, last day of month preceding the start of QE)

Sources: Bloomberg, L.P.; and IMF staff calculations.

Note: AAA = euro area countries with triple-A credit ratings; EA = euro area; QE = quantitative easing.

QE has also successfully signaled lower expected short-term interest rates (Christensen and Rudebusch 2012; Krishnamurthy and Vissing-Jorgensen 2011). The announced program was larger than expected and practically open-ended, signaling the ECB’s willingness to keep monetary policy accommodative until price stability is achieved. This has strengthened forward guidance and pushed short-term interest rates deeply into negative territory for maturities up to three years (Figure 6.5. and Figure 6.6).

Figure 6.6Portfolio Rebalancing and Signaling Effects

Sources: Bloomberg, L.P.; IMF 2013b; and IMF staff calculations.

Note: AAA = euro area countries with Triple-A sovereign credit rating; bps = basis points; QE = quantitative easing.

1 The carry-to-risk ratio is defined as the ratio of the spread difference between the 10-year and the 3-month risk-free rate (that is the term spread) to the implied volatility of the 3-month/10-year swaption; the lower the carry-to-risk ratio, the lower the risk of a reversal in the interest rate path towards monetary tightening.

2Core economies include Germany, France, and Netherlands

3Selected economies include Spain, Italy, and Portugal.

Looking ahead, portfolio rebalancing in Europe will likely depend on the reaction of different types of sellers (Figure 6.7). As of mid-2014, domestic private sector investors in the euro area held about 40 percent of their own government’s debt securities, compared to about 60 percent in the United Kingdom and the United States and about 82 percent in Japan at the start of their QE episodes (Benford and others 2009; Joyce, Tong, and Woods 2011; Saito, Hogen, and Nishiguchi 2014). There is wide variation across countries in Europe, with domestic residents holding about 25–30 percent of their own bonds in France and Germany, and about 60 percent in Italy and Spain. The euro area aggregation, however, treats intra–euro area holdings as foreign investment. After controlling for cross-country holdings within the euro area, non–euro area private sector investors held about 9 percent of the total, while other central banks account for most of non–euro area holdings (see Figure 6.23, panel 5). Several factors could prompt these players to change their portfolios:

  • Global reserve management changes could generate large flows—Since the global financial crisis, the euro’s share in global reserves has been declining (22 percent in 2014). If negative rates prompt central banks and the private sector to further reduce their euro allocations, this could lead to additional euro weakening (Figure 6.8).
  • Domestic nonbank resident holders, such as pension funds, mutual funds, and insurance companies, could diversify into foreign safe assets or other riskier domestic assets—Given statutory and regulatory requirements, European pension funds and insurance companies, which currently account for roughly 14 percent of total securities holdings, could opt for safe foreign assets (that is, U.S. government bonds), contributing to further weakening of the euro. Alternatively, a shift to riskier domestic assets would lower the private cost of borrowing.
  • Since the beginning of 2015, euro area banks have sold about 4 percent of domestic government and other euro area government debt, accounting for roughly 16 percent of securities holdings—If banks continue to sell, they could increase lending, as indicated by the ECB’s April 2015 Bank Lending Survey, or find other investments (Figure 6.17). According to the survey, banks indicated that they have used the additional liquidity mainly for granting loans, particularly to nonfinancial corporations and for refinancing both maturing debt and Eurosystem funding. Only a small percent of banks indicated that they have purchased other marketable assets. In both cases, this would comprise portfolio balancing toward greater risk taking, which would support growth and ultimately inflation.

Figure 6.7Investor Base of Euro–Area Government Debt Securities at the Start of QE Episodes

(Percent of total)

Source: Based on BIS data as of mid-2014 and using the methodology of Arslanalp and Tsuda (2012).

Figure 6.8Euro Share in Foreign Exchange Reserves

(Percent of all allocated reserves)

Source: IMF (2014).

Figure 6.9Stock Market Indices in Advanced Economies

(Index, 2009 = 100)

Source: Bloomberg, L.P.

Note: EA = euro area; GB = United Kingdom; US = United States; QE = quantitative easing.

Figure 6.10Household Total Assets, 2013

(Percent of total assets)

Source: ECB (2013).

Note: EA = euro area. Data labels in the figure use International Organization for Standardization (ISO) country codes.

Figure 6.11Nominal Exchange Rates in Advanced Economies

Source: Bloomberg, L.P.

Figure 6.12Openness Excluding Intra-Euro Area Trade

(Percent GDP)

Sources: IMF World Economic Outlook Database, Direction of Trade Statistics (IMF 2015a), and IMF staff calculations.

Figure 6.13Inflation-Linked Swap Rates in Euro Area

(Percent)

Source: Bloomberg, L.P.

Figure 6.14Medium- to Long-Term Inflation Expectations1

(Percent, year-over-year inflation rates)

Sources: Haver Analytics; Survey of Professional Forecasters; and Bloomberg, L.P.

Note: QE = quantitative easing; time t = quantitative easing episodes.

1 Euro area: 5y5y swaps; Japan QE2: 8–10 years ahead, one-month moving average, based on inflation swap bid and ask points; United Kingdom: five-year implied forward rate; US: Survey of Professional Forecasters median over next five years.

2United Kingdom’s inflation-indexed bonds are based on the retail price index inflation, which typically runs higher than consumer price index inflation.

Figure 6.15Inflation Expectations, Confidence, and Exchange Rate Effects

Sources: Bloomberg, L.P.; European Central Bank (ECB); Consensus Forecast; and IMF staff calculations.

Note: ESI = economic sentiment indicator; QE = quantitative easing.

1 The risk reversal can be interpreted as the market view of the most likely direction of the spot exchange rate over a specific maturity date based on the skew in the demand for call options at high strike prices. It is calculated as the difference between the implied volatility of out-of-the-money call options minus the implied volatility of out-of-the-money put options at the same distance to the strike price for a given maturity date.

Figure 6.16Credit Developments in Euro Area

Sources: ECB; Haver Analytics; and IMF staff calculations.

Note: EA = euro area; ECB = European Central Bank.

Figure 6.17Impact of Expanded Asset Purchase Program on Bank Lending Conditions

(Net percentage of respondents)

Source: ECB, Bank Lending Survey Statistics.

Figure 6.18Financial Fragmentation

Sources: Haver Analytics; Dealogic; Eurostat; ECB; and IMF staff calculations.

Note: CDS = credit default swap; CPI = consumer price index; ECB = European Central Bank. Core countries include Germany, France, and the Netherlands; selected countries include Spain, Italy, and Portugal.

Figure 6.19Loans to Private Sector in Advanced Economies

(Indexed to time t = start of QE episodes)

Sources: Haver Analytics; IMF, World Economic Outlook database; and World Bank, World Development Indicators.

Note: United States—Commercial bank credit to the private sector; Japan—Domestic monetary and financial institutions credit to the private sector; Euro area—Monetary and financial i nstitutions loans to private sector; United Kingdom—M4 monetary and financial institutions sterling net lending to private nonfinancial corporations and households.

Figure 6.20Nonperforming Loans in the Euro Area

(Percent of total loans)

Source: IMF, Financial Soundness Indicators.

Note: EU = euro area. Data labels in the figure use International Organization for Standardization (ISO) country codes.

Figure 6.21Size of Target Market and Maturity Term of Purchase under the PSPP, as of June 15, 2015

Sources: Barclays; Bloomberg, L.P.; ECB; EBA (Oct.2014); J.P. Morgan; and IMF staff calculations.

Note: EA = euro area; ECB = European Central Bank; PSPP = public sector purchase program.

1Excludes purchases of public securities from Greece and Cyprus due to collateral restrictions and purchasing limits as well as other EA countries. The Eurosystem also did not buy any government debt securities in Estonia as of May 1, 2015.

2Average maturity weighted by monthly purchases between March 9 and May 1, 2015.

3Greece and Cyprus are currently excluded from the PSPP.

4Includes Estonia, Latvia, Lithuania, Luxembourg, and Malta.

5Excludes bonds ineligible due to nominal yield below deposit facility rate (-20 basis points).

6Includes bonds ineligible due to nominal yield below deposit facility rate (-20 basis points).

7Purchases based on ECB capital key in market value terms, converted into nominal amounts.

8Calculations include eligible agency debt as per amended implementation details of April 15, 2015, and weighted according to the ECB capital key; eligible stock includes amount of net issuance (until 2016).

Figure 6.22Monitoring Sovereign Quantitative Easing

Sources: Barclays; Bloomberg, LP.; ECB; EBA (Oct. 2014); J.P. Morgan; and IMF staff calculations.

Note: EA = euro area; ECB = European Central Bank; PSPP = public sector purchase program;—= data not available.

1 Excludes purchases of public securities from Greece and Cyprus due to collateral restrictions and purchasing limits as well as other EA countries. The Eurosystem also did not buy any government debt securities in Estonia as of May 1, 2015.

2 Calculations include eligible agency debt as per amended implementation details of April 15, 2015, and weighted according to the ECB capital key; eligible stock includes amount of net issuance (until 2016).

3 Includes bonds ineligible due to nominal yield below deposit facility rate (-20 bps).

4 Purchases based on ECB capital key in market value terms, converted into nominal amounts.

5Greece (and Cyprus) are currently excluded from the PSPP.

6Includes Estonia, Latvia, Lithuania, Luxembourg, and Malta.

7Non-cumulative.

Figure 6.23Monitoring Sovereign Quantitative Easing

Sources: Barclays; Bloomberg, L.P.; ECB; ICAP; J.P. Morgan; Markit; and IMF staff calculations.

Note: EA = euro area; EONIA = Euro OverNight Index Average; SICAV = investment company with variable capital; UCITS = undertakings for the collective investment of transferable securities.

1 Includes the following EA countries: Austria, Belgium, Finland, France, Germany, Netherlands, Italy, Portugal, and Spain.

Asset Price Channel

With the announcement of QE, European stock prices surged, catching up with other advanced economies (Figure 6.9). The initial surge, driven by declines in risk premiums and the weaker euro, was partly reversed, with inflows to equity markets slowing during the second quarter of 2015. Looking ahead, equity prices could rise further if QE generates higher inflation, confidence, and growth. In other QE episodes, equity prices continued to rise well after the QE launch, in some cases, more than doubled (Joyce and others 2011).

Higher asset prices support spending by boosting wealth and collateral values:

  • Wealth effects—The generally low share of equity holdings by households is likely to limit the initial wealth effects stemming from higher stock prices (less so for households in Belgium and Germany given their larger holdings of bonds and equities) (Figure 6.10). The overall impact on consumption will also depend on house prices, with households in countries with higher real estate ownership rate (Spain, Portugal, Italy) benefiting more than core countries (Slacalek 2009). However, these wealth effects might be mitigated by cyclical weaknesses in the demand for housing and oversupply in some countries. Overall, empirical evidence suggests that while financial wealth effects are large, their impact on the economy is limited given their limited share in wealth (ECB 2013; Sousa 2009).
  • Increased collateral values—Higher asset values mean lower leverage, stronger corporate balance sheets, and better assessment of credit risks by banks. Higher real estate prices would also increase collateral valuations, supporting the credit channel.

Exchange Rate Channel

The euro has also depreciated substantially since mid-2014, despite recent corrections (Figures 6.11). As of May 2015, the euro has declined by 7 percent in nominal effective terms since September 2014. Factors affecting this include: (1) the divergent outlook for the monetary policy stance among advanced economies, (2) possible shifts to U.S. assets by European long-term investors in response to changing differences in real interest rates (possibly in combination with euro-funded carry trades), and (3) asset sales and shifts in reserve allocation away from the euro area. Overall, market expectations based on various indicators, including euro risk reversals,4 speculative positions, and correlation-weighted currency indices, suggest that the euro could weaken further.

A weaker euro will support exports and inflation but the impact will differ across the euro area (Figure 6.12). Broadly, the strength of the impact would depend on the degree of openness and trade elasticities. Excluding intra–euro area trade, exports and imports are about 30 percent of euro area GDP (similar to the United States and Japan, but lower than the United Kingdom). There is, however, cross-country heterogeneity, with Germany relatively more open than Italy, Spain, and France. On the other hand, according to the European Commission’s estimates, elasticities of exports with respect to the exchange rate are higher for countries with negative external debt positions, such as Italy, Portugal, and Spain (European Commission 2015).

Inflation Expectations and Confidence Channels

Inflation expectations for all time horizons have improved (Figure 6.13). Before the announcement of QE on January 22, 2015, inflation expectations across the board were on a declining trend. With QE, the secular decline in inflation expectations has been reversed, and the inflation outlook has improved, with the distribution of the consensus forecast for 2016 inflation narrowing and shifting to the right. This is similar to the effect that QE has had elsewhere in anchoring inflation expectations. In the United States and the United Kingdom, QE was launched early on during the global financial crisis, helping keep inflation expectations anchored. In Japan, inflation expectations picked up only after the Bank of Japan’s QE was combined with a comprehensive package of fiscal and structural policies (Figure 6.14).

Confidence has also improved (Figure 6.15). As expectations of QE intensified in late 2014 and oil prices fell, the decline in confidence indicators since early 2014 was reversed. These broader confidence effects could be quite powerful. For example, to the extent that QE leads to an improved economic outlook, it might release pent-up demand and bring forward spending, creating a positive feedback loop. Some of this more general improvement in confidence may also push up asset prices by reducing risk premiums.

Credit Channel

Financial conditions have improved, while fragmentation has declined. QE has reduced wholesale funding costs as portfolio rebalancing effects have led to a compression of bank bond yields (Figure 6.16 and Figure 6.18). The improvement in bank funding conditions since 2012 has recently translated into declines in deposit and lending rates. In particular, the dispersion between the core and selected countries has disappeared for deposit rates and shrunk considerably for lending rates. In addition, the divergence in deposit flows to banks has diminished, Target 2 imbalances have narrowed, and the decline in cross-border banking flows has slowed down. Nevertheless, it is still more expensive to borrow in selected countries, particularly in real terms, and deposit and bank flows have not recovered to precrisis levels.

Credit constraints have eased (Figure 6.16). Credit demand has picked up and the contraction of credit to the private sector has nearly ended. The ECB’s asset purchases have led to an easing of credit standards and terms as banks expect a boost to profitability due to capital gains, according to the Bank Lending Survey in April 2015 (Figure 6.17). Furthermore, with declining corporate bond yields, overall borrowing costs for firms have also fallen. Nevertheless, low inflation continues to keep real rates high, affecting more indebted countries in particular.

With the euro area largely a bank-based economy, the credit channel has been the main transmission channel of monetary policy to the real economy. The euro area is not, however, exceptional in its bank financing. Both the United Kingdom and Japan have a very large share of financial intermediation through banks, but QE has worked there through a combination of channels.

In addition to channels discussed earlier, the ECB’s asset purchases support bank lending through lower lending rates, improved bank balance sheets and the corporate balance sheet channel through improved collateral values, higher expected growth, and lower leverage.

However, credit recoveries after QE typically take more time. In Japan in 2001 and the United States in 2008, credit picked up only two to three years after financial sector problems were dealt with. Even with sounder financial systems, credit could still respond slowly (for example, Japan in 2010 and the United Kingdom in 2009), mainly due to weak investment demand (Figure 6.19).

In the euro area, high nonperforming loans (NPLs) remain an obstacle to a credit recovery (Figure 6.20). The ECB’s Comprehensive Assessment, which concluded in October 2014, revealed high NPLs in several banking systems, with considerable variation among countries. High nonperforming loans result in lower profitability and tie up substantial amounts of capital that could otherwise be used for new lending (Aiyar and others, forthcoming). Rising asset prices and an improved outlook are likely to increase credit demand, including through higher collateral values and higher expected earnings, providing an opportunity for banks to restart lending. But weak bank balance sheets and the large private sector debt overhang will likely hold back investment.

Implementation and Design of Asset Purchases

Addressing Potential Asset Scarcity

The transmission channels of QE are also affected by the design and the implementation of asset purchases. These relate to (1) the scale and scope of the target market, (2) the willingness of different financial institutions to sell assets, and (3) the functioning of markets in distributing excess liquidity and market making.

The potential scarcity of sovereign bonds may pose challenges for implementation. Staff analysis (Table 6.1 and Figure 6.21) suggests that based on current trends, some national central banks (NCBs) might have difficulty meeting their target purchases due to the combined effect of the price cap on purchases (that is, no purchase of securities with a yield less than the deposit rate of 0.2 percent), a shrinking net supply of government debt, and purchases of longer-dated debt securities held predominantly by long-term investors that are less inclined to sell. More specifically, the following factors could raise challenges for meeting the target volumes:

  • Nominal limits restrict the overall scale of the target market—The impact of the nominal security issue and issuer limits of 25 and 33 percent, respectively, is offset somewhat as the Eurosystem’s purchase targets refer to settled amounts (in market value terms). This implies lower nominal amounts of purchases of bonds that trade above par. Targeting purchases in market value terms makes it easier to comply with nominal purchasing limits, and even more so at longer durations (where bonds trade at a higher price premium) (Annex 6.1). However, for some countries, even lower (implied) nominal target volumes come very close to the maximum eligible amount after applying nominal limits (Figure 6.21).
  • The target market is likely to shrink due to low net supply of government debt—The Eurosystem is expected to purchase a nominal amount of government bonds that will exceed net new issuance by €239 billion annually (or about 5 percent of the eligible stock) (Figure 6.22). A shrinking target market enhances the effectiveness of portfolio rebalancing, but also reduces the amount of securities available for purchase over time. However, targeting purchases in market value terms lowers the nominal amount of purchases (if bonds trade above par), and thus could mitigate the extent to which asset purchases further diminish a declining stock of outstanding government debt.
  • Price cap on asset purchases varies with market conditions—The cap on purchases of securities with nominal yields below the current –0.2 percent deposit rate reduces the pool of eligible sovereign assets subject to changes in market. This currently affects about 5 percent of the total eligible stock and about 14 percent of German government debt (as of June 21, 2015). The price cap could lengthen the average maturity of purchases, which benefits countries that issue longer-dated bonds, but also risks overweighting purchases at longer maturities in smaller markets.
  • The scope for substitute purchases by NCBs is limited—The shrinking pool of eligible securities raises the importance of other eligible nongovernment debt securities, such as agency and supranational debt (Annex 6.1).5 However, the list of eligible agency debt remains restrictive even after recent amendments, suggesting a possible constraint on agency purchases in noncore countries. With approval from the Governing Council, substitute purchases could also include other national public nonfinancial entities which are not currently eligible, and European Union agencies.6 Also, purchases of marketable debt instruments issued by supranational organizations are possible if NCBs run out of eligible central government and national agency debt. However, purchases of supranational debt are undertaken exclusively by two designated NCBs on behalf of the ECB under full risk sharing (and are capped at 12 percent of purchases) so any substitute purchases by NCBs would raise the overall purchases of supranational debt. This adds to the overall importance of the near-term supply of supranational debt and is particularly relevant in countries with smaller government debt markets relative to target purchase amounts. In addition, the eligibility criteria for private sector asset purchases are slightly more stringent than those for public sector purchases.7
  • Weighting asset purchases by nominal outstanding amounts along the term structure shifts purchases toward longer maturities—Since the market value of longer-dated bonds is on average higher than shorter-dated bonds, this implies a greater share of purchases of longer-dated securities in market value terms. However, banks’ asset holdings decline dramatically at maturities beyond 10 years (Figure 6.22 and Figure 6.24), and especially so in the more selected economies. Since the share of purchases is higher for low-yielding debt issued in core economies, it further strengthens the duration effect of purchases, but it also increases demand for long-dated assets to a point where the security issue limit may become more binding.
  • The pool of “willing” sellers shrinks at longer maturities—Nonbank financial institutions, such as insurance companies and pension funds, hold long-dated sovereign debt for asset-liability matching, and account for about 20 percent of the investor base in the euro area (Figure 6.23). Regulatory requirements, such as asset-liability matching, and accounting standards, such as hold-to-maturity valuation, discourage nonbank financial institutions from selling debt securities. In addition, rising reinvestment risk in a low-interest rate environment, disproportionately higher capital charges for riskier investments, and the lack of substitutes for sovereign debt as a liquidity buffer also serve as disincentives. For banks, yields on their government debt holdings (€271 billion) have fallen below the deposit facility rate (Figure 6.22), limiting their incentive to sell. At the same time, incentives to sell sovereign debt and reinvest in highly-rated foreign assets (such as U.S. government bonds) have increased as the difference between the U.S. and euro term spreads continues to widen in real terms (Figure 6.15).
Table 6.1.Detailed Analysis of Target Market under the ECB Public Sector Asset Purchase Program (PSPP) as of May 8, 2015(Nominal amounts, EUR billion)
Government and Agency Debt Securities
Government Debt (current)Agency Debt (current)Agency Debt (potential)Supranational Debt (potential)
CountryECB Target Purchase Amount (market value)Implied ECB Target Purchase Amount1Eligible Amount2Share of PurchasesEligible Amount3Share of PurchasesMax. Eligible Amount3Share of PurchasesPotential Amount4Share of PurchasesTotal Reduction
[a][b]P1=a/b[c]p2 = (b + c)/a[d]p3 = (b + c + d)/a[e]p4 = (b + c + d + e)/asum(p1-p4)
Austria23.518.437.349.349.35.343.22.540.9−8.5
Belgium29.622.465.834.134.134.13.132.6−1.5
Finland13.911.919.860.10.359.20.359.21.555.2−4.9
France169.4132.4282.846.830.342.341.840.817.8387−8.1
Germany244.4195.6195.3100.241.482.647.380722.673.8−26.4
Greece24.7*44.5*57.543.043.043.02.641.1−1.8
Ireland15.011.728.341341.341.31.639.1−2.2
Italy147.1118.3326.836.21.636.01.936.015.534.4−1.8
Netherlands47.838.565.858.510.350.610.350.65.047.5−11.0
Portugal20.817.121.380.480.40.680.42.271.0−9.4
Spain105.683.8165.350.74.249.57.948.411.145.5−5.2
All Others22.622.129.275.875.875.82.569.7−6.0
Total839.6672.21,294.751.988.148.6115.247.787.944.9−7.0
Sources: Bloomberg LP.; ECB; and IMF staff calculations.Note:—= data not available; ECB = European Central Bank.

Applies market value of eligible bonds at end of April 2015 to infer the actual purchase amount in nominal terms.

Considers net issuance, subject to issue/issuer limits (including securities market program), but includes bonds trading below the deposit rate cap.

Subject to issue limit but includes bonds trading below the deposit rate cap, and based on ECB capital key.

Subject to issue limit but includes bonds trading below the deposit rate cap, and based on ECB capital key, assuming that ECB purchases of supra-national debt are conducted by national central banks (without risk sharing).

Currently no purchases of Greek debt under the expanded asset purchase program.

Sources: Bloomberg LP.; ECB; and IMF staff calculations.Note:—= data not available; ECB = European Central Bank.

Applies market value of eligible bonds at end of April 2015 to infer the actual purchase amount in nominal terms.

Considers net issuance, subject to issue/issuer limits (including securities market program), but includes bonds trading below the deposit rate cap.

Subject to issue limit but includes bonds trading below the deposit rate cap, and based on ECB capital key.

Subject to issue limit but includes bonds trading below the deposit rate cap, and based on ECB capital key, assuming that ECB purchases of supra-national debt are conducted by national central banks (without risk sharing).

Currently no purchases of Greek debt under the expanded asset purchase program.

Improving Collateral Availability

Sovereign debt purchases may also impair market functioning (so-called financial plumbing) if they significantly diminish the availability of debt securities for securities lending. Assets purchased by the Eurosystem are also valued by market participants for their collateral services (Cœuré 2015; Singh 2014). Unlike the order-book8 model of price formation in equity markets, government bond markets are mostly over the counter and rely predominantly on market makers, who compete for customer order flow through buy and sell quotations (“two-way prices”). These market makers optimize their inventory of bonds by selling short and carrying open positions, which requires liquid hedging markets and efficient securities financing transactions, that is, repos and securities lending. Most government debt securities serve as liquid, fixed-duration, and high-quality collateral for these activities.

A decrease in the available debt securities that can be used as collateral in repo markets may adversely affect market making for government bond markets.9 And since most sellers of sovereign assets are also important securities lenders, asset purchases could reduce the stock held by those that are more likely to engage in securities lending. Data on the current volume of securities lending and the utilization of government bonds suggest that the aggregate lendable collateral value has already declined by almost 12 percent (or €78 billion) since the end of August 2014 (with the utilization rate of available collateral increasing), and is expected to further contract (Figure 6.23).

The importance of the Eurosystem’s securities lending activities varies across countries. Similar to portfolio rebalancing as transmission channel for asset purchases, the availability of collateral for market making is influenced by the size of market, the composition of the investor base, the net issuance by governments, and the maturity of government bonds for securities lending. The interaction between monetary conditions and the willingness of investors to lend securities is an important consideration in this regard:

  • Excess liquidity could diminish supply of collateral in the core economies—Banks, which tend to be more active lenders of collateral (Figure 6.23), generally hold a liquidity surplus in the core economies. They also face limited incentives to engage in cash-based securities lending due to the lack of attractive investment opportunities.10 Instead, much like in Eurosystem’s securities lending, they are likely to prefer lending out government bonds in return for other government bonds with higher yields and/or longer maturities (as “collateral swaps” via mutually offsetting repo and reverse repo transactions)—but this does not expand available collateral for market making. In addition, most NCBs in the core economies, which account for a large amount of PSPP purchases, do not accept nondomestic government debt as collateral, preventing a net release of highly sought-after collateral, such as German government debt by the Deutsche Bundesbank.
  • Strong incentives to securities lending by banks in non-core economies—Negative deposit rates reduce incentives for banks to hold excess liquidity and encourage lending (or investment). In the case of Italy and Spain, for instance, the amount of government debt securities held by domestic investors has risen substantially since 2011—and over 60 percent by the end of 2014. In addition, most investment securities held by euro area banks are valued on either a mark-to-market for trading or fair value basis for assets for sale, with generally less than 20 percent being held to maturity. This suggests strong incentives for securities lending when interest rates decline, which bodes well for the availability of collateral.
  • Shrinking pool of “willing” securities lenders—Collateral scarcity is more likely to arise at longer maturities and in countries where the net supply of government bonds is small (or even negative). Banks tend to hold government bonds at the front end of the eligible range of maturities (for example, more than 80 percent of government debt holdings of European banks have a residual maturity of less than 10 years) (Figures 6.22 and 6.24), and are less likely to engage in securities lending at longer maturity tenors. Moreover, nonbank financial institutions with long-term liabilities face supervisory standards that discourage active collateral management. Insurance companies and pension funds are generally less active in repo markets, and in most countries are barred from engaging in securities lending and liquidity swaps with banks or asset managers. Similarly, the high foreign official sector holdings of government debt of some core economies (outside the Eurosystem) remove collateral from securities lending within the euro area.

Figure 6.24Bank Holdings of Government Debt in Euro Area

(Percent)

Sources: Barclays; Bloomberg LP; ECB; J.P. Morgan; and IMF staff calculations.

Note: EA = euro area; PSPP = public sector purchase program. Data labels in the figure use

International Organization for Standardization (ISO) country codes.

Based on these considerations, current securities lending by NCBs might be insufficient.11 Securities lending aims to ease the reduced availability of collateral for market making while avoiding sterilizing the impact of asset purchases on aggregate liquidity. The ECB’s securities lending works well and has established clear and effective standards that helped build confidence in the availability of collateral (Annex 6.2). The ECB operates a centralized securities lending program of own bonds bought under the PSPP without maturity restrictions, but at very small amounts per issue (of up to 2.5 percent of the notional amount). Although the ECB’s securities lending allows collateral access to a wide range of market participants, it provides only a small backstop against potential collateral scarcity, since most of its securities lending remains decentralized under NCBs. Some 80 percent of the PSPP’s current stock is held by NCBs, whose securities lending is marked by considerable cross-country variation in conditions on pricing, haircuts, and eligibility. This could undermine transparency and limit equitable access to collateral for market makers across the euro area. In the absence of sufficient centralized securities lending, purchases by NCBs could reduce access to collateral for market-making activities outside their domestic market. In addition, cash (or equity) cannot be posted straight in exchange for bonds, which excludes market makers who often use these assets when borrowing securities.12

Conclusion and Policy Recommendations

Given the risks of prolonged low inflation, the ECB should stay the course until inflation is on a sustained adjustment path. Despite recent market corrections, various channels, particularly the expectations channel, likely play a significant role in transmitting an ECB balance sheet expansion into higher inflation. If inflation and inflation expectations fail to pick up after a reasonable period of QE, the ECB should stand ready to extend the asset purchase program beyond September 2016. The Governing Council should look through current market volatility and transient changes in inflation in signaling its monetary policy stance. Continued clear communication of the Governing Council’s intentions will help mitigate excessive market volatility and reinforce its commitment to meeting the ECB’s aim of achieving inflation rates below, but close to, 2 percent over the medium term (Praet 2015).

Dealing with bank and corporate balance sheet problems would increase the effectiveness of QE. Reducing NPLs is a policy priority, not only to restore the health of the banking sector, but also to strengthen monetary transmission via the bank lending channel. It also remains essential that the accommodative monetary stance be supported by comprehensive and timely policy actions in other areas, not least structural reforms to boost potential growth.

Potential implementation challenges could be overcome by expanding the flexibility of the current asset purchase program, and enhancing access to collateral for market makers within a common securities lending framework:

  • Expand flexibility of asset purchases—The Eurosystem could widen the eligibility of agency debt, increase purchases of supranational debt (Table 6.1),13 and relax the eligibility criteria for private sector assets, which are slightly more stringent than those for public sector purchases with the same risk. This would help NCBs meet purchasing targets in their home markets without breaching the single issue and issuer limits imposed by the PSPP. Measured deviations from the capital key-based allocation of purchases might be warranted if purchases risk diminishing market liquidity at certain (longer) maturity terms. Substitute purchases of sovereign and agency debt in other jurisdictions do not seem to be explicitly ruled out by the implementation guidelines of the purchase program and should be considered if necessary.
  • Enhance market making through harmonized securities lending—The ECB should develop high-level principles to harmonize procedures for securities lending and encourage a common active lending solution for all NCBs,14 for example, joint securities lending with specialized agents and coordinated by the ECB (Figure 6.25). The aim would be to improve transparency, pricing, and the availability of collateral for market making, and so support sufficient market liquidity.15 This would enhance the effectiveness of the Eurosystem’s asset purchases, especially for securities in smaller markets or at maturities with low trading activity. The NCBs’ acceptance of nondomestic government debt as collateral and price-based incentives could help ensure that dealers only access the ECB’s centralized securities lending facility as a last resort.

Figure 6.25Solutions for Active Securities Lending

Source: ECB.

Note: ECB = European Central Bank; RWA = risk-weighted assets.

Annex 6.1. The Expanded Asset Purchase Program (APP)

The expanded asset purchase program (APP) was announced on January 22, 2015, and started on March 9. It consists of combined monthly purchases of €60 billion in public and private sector securities with a residual maturity of at least two years (but not greater than 30 years) in the secondary market.

The public sector assets purchase program (PSPP) represents more than 80 percent of the volume generation under the APP and comprises euro-denominated marketable debt instruments issued by euro area central governments, certain agencies located in the euro area, or certain international or supranational institutions in the euro area. It complements existing private asset purchases under the CBPP3 and ABSPP (Annex Figure 6.1.1). Purchases are conducted by both the ECB and national central banks in their home market, with the possibility of purchasing marketable debt instruments issued by agencies and international or supranational institutions located in the euro area if needed to meet each country’s allocation based on the ECB’s capital key (“substitute purchases”).

Annex Figure 6.1.1Overview of the Expanded Asset Purchase Program

Source: ECB.

Note: ECB = European Central Bank; EU = European Union; NCB = national central banks.

1 Empirically derived based on settled purchases as of June 7, 2015.

2Via four European and one international asset management companies.

Several restrictions are placed on asset purchases. The ECB introduced a cap on purchases of securities with yields below the –0.2 percent deposit rate (which does not apply to inflation-linked securities). Moreover, asset purchases are subject to a 25 percent limit on the notional amount of each issue (“issue share limit”) together with a 33 percent limit on the total outstanding amount per issuer (“issuer limit”). The issue share limit covers existing Eurosystem holdings of securities used for monetary operations (that is, stock under the securities markets program) and any other portfolios owned by Eurosystem central banks.

Annex 6.2. Securities Lending Under the Expanded Asset Purchase Program (APP)

On April 2, 2015, the European Central Bank (ECB) and several Eurosystem national central banks (NCBs) began making available securities purchased under the public sector purchase program (PSPP) and asset holdings under the securities market program. Holdings of securities purchased under the program are eligible for securities lending to facilitate bond and repo market liquidity. Securities are made available in a decentralized manner, mirroring the organization of the PSPP by replicating existing private sector solutions, with a small amount of securities purchases by the ECB itself under the PSPP being provided centrally via the existing settlement system for failed trades. The program primarily targets market-making institutions. Lending of PSPP-securities holdings takes place on a “cash neutral basis” (that is, repo transactions against cash collateral are accompanied by a fully offsetting reverse repo transaction and typically with the same counterparty).

More specifically, the Eurosystem follows a two-pronged securities lending program:

  • Centralized securities lending—The ECB offers securities that it has directly purchased at a fixed fee of 40 basis points for one week, which can be rolled over up to three times at an incremental cost of 10 basis points per additional week. The amount lent for each bond cannot exceed the lower of €200 million or 2.5 percent of the outstanding notional amount. Lending is funded via a noncash repo at a collateral haircut of 4 percent. All securities that fulfill the PSPP requirements are accepted as collateral, even if their residual maturity is lower than two years. This allows borrowers to “upgrade” collateral by posting short-dated government debt in exchange for longer-dated, higher-yielding government debt, which offers a potential pricing benefit in an environment of continued spread compression. This should support collateral rates in selected economies; for instance, as a result of swapping five-year German Bunds against a 30-year Italian treasury bond. It might also contribute to reduced fragmentation of lending rates between core and selected economies. However, these conditions apply only to bonds bought directly by the ECB, which represents a maximum of 20 percent of all asset purchases under the risk-sharing arrangement of the asset purchase program.
  • Decentralized securities lending—NCBs, which complete most of the purchases under the PSPP (80 percent, Annex 6.1), conduct their own securities lending programs, and are able to set different conditions and use different channels of lending securities to the market. They employ the channels for securities lending available under their existing infrastructure for mitigating settlement failures. This includes bilateral securities lending and lending relying on specialized securities lending agents (“agency lending”) or on the lending infrastructure of international central securities depositories (ICSDs). NCBs lend acquired bonds using collateral swaps or fails mitigation programs by ICSDs, and some NCBs make their securities available in Euroclear’s automated securities lending and borrowing program for the purpose of mitigating settlement fails caused by the lack of specific collateral. Bonds are lent at more expensive levels compared to general collateral, which are influenced by market conditions.16 Several NCBs have added some restrictions to securities lending on the maturity of the operation as well as on the size of transactions. They might also apply their own risk management framework, which determines, for instance, collateral eligibility, pricing, haircuts, and term, and counterparty eligibility.
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This chapter is based on Euro Area Policies: 2015 Article IV Consultation—Selected Issues, IMF Country Report 15/183, 2015. Research support was provided by Jesse Siminitz.

1

This implies a lower nominal volume of asset purchases if bonds trade above par value on average.

2

QE is the commonly used term to describe the ECB’s expanded asset purchase program (APP). APP includes the purchase of public sector securities issued by euro area governments, agencies, and supra-national organizations, in addition to pre-existing programs to purchase private asset-backed securities and covered bonds. Public sector–issued securities make up the bulk of APP purchases (more than 80 percent) and constitute more than two-thirds of asset holdings under QE (as of mid-July).

3

The size-weighted average maturity of Eurosystem holdings under the PSPP was 8.1 years after three months of purchases (as of end-June 2015).

4

The risk reversal can be interpreted as the market view of the most likely direction of the spot exchange rate over a specific period of time. It is calculated as the difference between the implied volatility of out-of-the-money call options minus the implied volatility of out-of-the-money put options at the same distance to the strike price for a given maturity date.

5

The volume of eligible outstanding agency and supranational debt for potential “substitute purchases” is about €756 billion. Recognizing all issuers categorized as euro area agencies would increase the total volume from €357 billion to €430 billion.

6

Increased buying of debt in other jurisdictions does not seem to be explicitly ruled out.

7

Whereas the best available credit rating determines eligibility (“first-best rule”) under the PSPP, the ECB requires asset-backed securities and covered bonds to have two ratings at the maximum achievable rating level (“second-best rule”).

8

An order book is the list of orders (manual or electronic) that a trading venue (in particular stock exchanges) uses to record the interest of buyers and sellers in a particular financial instrument.

9

Collateral scarcity raises the cost of short selling, which would curtail the ability of market makers to generate two-way flows that are essential to efficient price discovery in government bond markets.

10

This might push repo rates below the levels set by the ECB and NCBs in their securities lending program (which is already becoming apparent as general collateral repos on German and French government bonds), which trade at spreads of more than–20 bps to the 12-month Euro OverNight Index Average (EONIA) rate (Figure 6.23).

11

Other major central banks that have completed a QE program adopted a centralized and active securities lending program. The Federal Reserve used the System Open Market Accounts Program of up to 90 percent per issue (http://www.newyorkfed.org/markets/soma/sysopen_accholdings.html). The Bank of England adopted a three-stage process of lending to market counterparts, which comprised (1) direct lending by the HM Treasury’s Debt Management Office of own inventory, (2) the bank’s standard repo facility (since 2009) if the office’s inventory is exhausted, and (3) making a portion of their purchases available to the Debt Management Office for lending with a negotiated borrowing fee. The Bank of Japan lent Japanese government bonds via auction-based repo agreements (using the New Gensaki trade type) to provide a temporary and secondary source of these instruments to the market to enhance liquidity.

12

Also, most NCBs do not use specialized agents for securities lending, which creates legal uncertainty regarding netting provisions due to sovereign immunity clauses.

13

On July 1, 2015, the ECB added corporate bonds issued by 13 government-owned entities from across the euro area to the list of assets eligible for purchase.

14

This approach would ideally be supplemented with accessing the lending infrastructure of international central securities depositories. It would also require introducing a minimum fail charge (to prevent opportunistic settlement fails) and creating a legal arrangement that leverages the concept of the Global Master Repurchase Agreement Protocol to create legal certainty in NCB-sponsored securities lending.

15

As part of alleviating pressures on the availability of collateral, both the ECB and NCBs could also reduce the valuation haircuts for bond collateral, raise the limit on securities lending per issue, extend standard maturity terms (or reduce extra charge for rollovers), and accept equity as noncash collateral.

16

While unsecured lending prices for Eurosystem banks cannot drop below the rate offered by the ECB’s deposit facility, repo rates can, and do. Despite the recent market correction, even general collateral repos of French and German government debt securities still trade at more than 20 basis points below the EONIA rate (Figure 6.25).

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