Euro Area Policies: Selected Issues
Author: International Monetary Fund. European Dept.
Publication Date:
27 Jul 2015
eISBN:
9781513523088
Language:
English
Keywords:
ISCR; CR; Reducing NPLs; bank; purchase; lending; asset purchase; issue limit; inflation expectation; financial condition; market value; Unconventional monetary policies; Collateral; Sovereign bonds; Global
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Euro Area Policies: Selected Issues

Abstract

Euro Area Policies: Selected Issues

An Early Assessment of Quantitative Easing1

Following a series of easing measures, the ECB announced a sovereign asset purchase program in January 2015. Since its start, sovereign QE has had a positive effect on financial conditions and inflation expectations. Its impact on the real economy will take more time and is likely to depend on supportive steps to strengthen bank and corporate balance sheets. Other steps to strengthen its effectiveness include increasing the flexibility for substitute purchases and asset eligibility and harmonizing the terms of securities lending by the Eurosystem to ensure smooth market-functioning.

A. Introduction

1. The ECB has taken a series of easing steps since mid-2014. These include a negative deposit facility rate and targeted longer-term refinancing operations (TLTROs) to support new lending. In September 2014, the ECB announced a private asset purchase program comprising asset-backed securities (ABS) and covered bonds (ABSPP and CBPP3) and began purchases in 2014Q4 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.

2. In January 2015, the ECB announced the addition of sovereign assets to its asset purchase programs (Annex 2 and Figure 4). The expanded asset purchase program (APP) is effectively open-ended and was larger than expected. The scale of additional sovereign asset purchases (about €840 billion in market value terms2 under the Public Asset Purchase Programme (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 QE in March 2015, the ECB has expanded its balance sheet by almost 19 percent (as of June 30). Combined purchases of public sector securities, covered bonds and asset-backed securities under the APP amount to €297 billion, with the split heavily skewed towards sovereign assets (€194 billion, Figure 4).

Figure 1.
Figure 1.

Monitoring the Aggregate Effect of Sovereign QE (Financial Sector)

(as of June 22, 2015)

Citation: IMF Staff Country Reports 2015, 205; 10.5089/9781513523088.002.A002

Figure 2.
Figure 2.

Size of Target Market and Maturity Term of Purchase under PSPP

(as of June 15, 2015)

Citation: IMF Staff Country Reports 2015, 205; 10.5089/9781513523088.002.A002

Sources: Barclays; Bloomberg LP; ECB; EBA (Oct. 2014); J.P. Morgan; and IMF staff calculations.Note: 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/ Purchases based on ECB capital key in market value terms, converted into nominal amounts. 4/ excludes bonds ineligible due to nominal yield below deposit facility rate (-20 bps). 5/ Average maturity weighted by monthly purchases between March 9 and May 1, 2015. 6/ includes bonds ineligible due to nominal yield below deposit facility rate (-20 bps). (*) Greece (and Cyprus) are currently excluded from the PSPP. (**) includes Estonia, Latvia, Lithuania, Luxembourg, and Malta.
Figure 3.
Figure 3.

Solutions for Active Securities Lending

Citation: IMF Staff Country Reports 2015, 205; 10.5089/9781513523088.002.A002

Figure 4.
Figure 4.
Figure 4.
Figure 4.

Monitoring Sovereign QE

Citation: IMF Staff Country Reports 2015, 205; 10.5089/9781513523088.002.A002

3. The ECB also took steps to strengthen transparency and communications. Starting in 2014, the ECB 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 (GC)’s view. In March 2015, the GC clarified its intention (i) to continue the purchases until it sees a sustained adjustment in the path of inflation and at least until September 2016; and (ii) to concentrate on trends in inflation, looking through transient factors that do not affect the medium-term outlook for price stability. In June, the GC 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.

4. This paper assesses the effectiveness and implementation of QE to date. The next section (Section B) explores transmission channels and their impact on macro-financial conditions. Section C presents a simulation examining the impact of a further decline of the exchange rate, improved credit conditions, and higher inflation expectations; and their spillover effects to the rest of the world. Section D examines the design and implementation of asset purchases and explores their influence on the effectiveness of QE. Section E concludes with policy recommendations.

B. QE’s Transmission Channels and Initial Assessment

6. The ECB’s QE had an immediate impact on financial conditions and expectations. The initial market impact was stronger and broader than expected, with higher inflation expectations (expectations channel), lower term spreads across the euro area (portfolio rebalancing and signaling channels), 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). While the recent surge in bond market volatility has unwound some earlier gains in asset prices, financial conditions are still easier than before.

7. 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 on inflation between three to 16 quarters (IMF, 2013b). Engen and others (2015) estimate that the response of unemployment and inflation to the Fed’s QE policies since early 2009 peaks in 2015 and 2016, respectively. In particular, a credit recovery typically takes more time, especially if banks’ asset quality is still weak (IMF, 2015).

Portfolio rebalancing and signaling (Figure 5)

Figure 5.
Figure 5.

Portfolio Rebalancing and Signaling Effects

Citation: IMF Staff Country Reports 2015, 205; 10.5089/9781513523088.002.A002

Sources: Bloomberg, L.P.; IMF Policy Paper, Global Impact and Challenges of Unconventional Monetary Policies (Oct. 2013). and Fund staff calculations.Note: 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 (i.e., the term spread) to the implied volatility of trie 3-montiy10-year swaption; the lower the ca rry-to-risk ratio, the l ower the risk of a teversal in the interest rate path towards monetary tightening. 2/ Core economies include DEU, FRA, and NLD; 3/ Selected economies include ESP, ITA, and PRT.

8. Despite recent market corrections, term spreads remain low in selected countries and in the euro area as a whole.3 Core countries’ term spreads, however, have reverted to near their levels in September 2014. Initial declines were sizeable across the board, particularly given already low yields (relative to that of US and the UK government bonds). Given the price cap on negative rates (Section D), purchases initially focused on the longer end,4 strengthening the decline in term spreads. This decline reflected a combination of factors including expected short-term interest rates (signaling) and term premia (as a result of both the duration and scarcity effects given the long maturity of purchases). QE has also successfully signaled lower expected short-term interest rates. 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.

A02ufig1

Eonia

(Effective Yield (bps), since Sep. 2014)

Citation: IMF Staff Country Reports 2015, 205; 10.5089/9781513523088.002.A002

A02ufig2

Change in Term Spread

(bps)

Citation: IMF Staff Country Reports 2015, 205; 10.5089/9781513523088.002.A002

A02ufig3

Sovereign Yield Curves

(Percent, last day of previous month of QE)

Citation: IMF Staff Country Reports 2015, 205; 10.5089/9781513523088.002.A002

9. Looking ahead, portfolio rebalancing in Europe will likely depend on the reaction of different types of sellers. 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 U.K. and the U.S. and about 82 percent in Japan at the start of their QE episodes. 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-EA holdings as foreign investment. After controlling for cross-country holdings within the EA, non-EA private sector investors held about 9 percent of the total, roughly comparable to other advanced economies, while other central banks account for most of non-EA holdings (Figure 4). Several factors could prompt these players to change their portfolios:

A02ufig4

Investor base of Euro Area Government Debt Securities at the start of the QE Episodes

(Percent of total)

Citation: IMF Staff Country Reports 2015, 205; 10.5089/9781513523088.002.A002

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

  • Global reserve management changes could generate large flows. Since the 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.

  • Domestic non-bank 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 (i.e., U.S. government bonds), contributing to further weakening of the euro. On the other hand, a shift to riskier domestic assets would lower the private cost of borrowing.

  • Since the beginning of this year, 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 (BLS), or find other investments. According to the BLS, banks indicated that they have used the additional liquidity mainly for granting loans, particularly to non-financial corporations (NFCs) and for refinancing 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 towards greater risk-taking, which would support growth and ultimately inflation.

A02ufig5

Euro Share in Foreign Exchange Reserves

Citation: IMF Staff Country Reports 2015, 205; 10.5089/9781513523088.002.A002

Asset price channel

10. With the announcement of QE, European stock prices surged, catching up with other advanced economies. The initial surge, driven by declines in risk premia and the weaker euro, was partly reversed, with inflows to equity markets slowing down more recently. 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 doubling.

A02ufig6

Stock Market Index

(Index, 2009=100)

Citation: IMF Staff Country Reports 2015, 205; 10.5089/9781513523088.002.A002

11. 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). The overall impact on consumption will also depend on house prices, with households in countries with higher real estate ownership rate (Spain, Portugal and Italy) benefiting more than core countries. However, these wealth effects might be mitigated by cyclical weaknesses in the demand for housing and oversupply in some countries. Overall, past empirical evidence suggests that while financial wealth effects are large, their impact on economy is limited given their limited share in wealth (ECB, 2013; Sousa, 2009).

  • Increased collateral values. Higher asset values mean lower leverage, strengthening corporate balance sheets, and banks’ assessment of credit risks. Higher real estate prices would also increase collateral valuations, supporting the credit channel.

A02ufig7

Household Total Assets

(Percent of total assets and debt)

Citation: IMF Staff Country Reports 2015, 205; 10.5089/9781513523088.002.A002

Source: ECB, 2013.

Exchange rate channel (Figure 6)

Figure 6.
Figure 6.

Exchange Rate Effects

Citation: IMF Staff Country Reports 2015, 205; 10.5089/9781513523088.002.A002

Sources: Bloomberg, L.P.; IMF, World Economic Outlook; and Fund staff calculations.Note: 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. 2/ The correlation-weighted currency index provides an indication of the relative strength or weakness of one currency against a basket of the G-10 currencies and can then be used as the basis for hedging against exposure to adverse movements of the respective currency.

12. The euro has also depreciated substantially since mid-2014, despite recent corrections. As of May 2015, the euro has declined by 7 percent in nominal effective terms since September 2014. Factors affecting the recent movement in the exchange rate include: (i) the divergent outlook for monetary policy stance among advanced economies; (ii) possible shifts to U.S. assets by European long-term investors; and (iii) asset sales and shifts in reserve allocation away from the euro area. Overall, market expectations based on various indicators, including euro risk reversals,5 speculative positions, and correlation-weighted currency indices, suggest that the euro could weaken further going forward.

A02ufig8

Nominal Exchange Rates

Citation: IMF Staff Country Reports 2015, 205; 10.5089/9781513523088.002.A002

13. A weaker euro will support exports and inflation but the impact will differ across the euro zone. 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 U.S. and Japan, but lower than the U.K.). 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 exchange rate are higher for countries with negative external debt positions, such as Portugal, Italy, and Spain (European Commission, 2015).

A02ufig9

Openness Excluding Intra-EA Trade

(Percent GDP)

Citation: IMF Staff Country Reports 2015, 205; 10.5089/9781513523088.002.A002

Inflation expectations and confidence channels (Figure 7)

Figure 7.
Figure 7.

Inflation Expectations and Confidence

Citation: IMF Staff Country Reports 2015, 205; 10.5089/9781513523088.002.A002

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

14. Inflation expectations at all time horizons have improved. Before the announcement of QE on January 22, inflation expectations across the board were on a declining trend (text figures). With QE, the secular decline in inflation expectations has been reversed, and the inflation outlook has improved, with the distribution of 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 U.S. and the U.K., QE was launched early on during the global financial crisis, helping keep inflation expectations anchored. In Japan, inflation expectations picked up only after the BoJ’s QQE was combined with a comprehensive package of fiscal and structural policies.

15. Confidence has also improved (Figure 7). 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 premia.

A02ufig10

Euro Area: Inflation-linked Swap Rates

(Percent)

Citation: IMF Staff Country Reports 2015, 205; 10.5089/9781513523088.002.A002

A02ufig11

Medium to Long-term Inflation Expectations 1/

(Percent; YoY inflation rates; time t = QE episodes)

Citation: IMF Staff Country Reports 2015, 205; 10.5089/9781513523088.002.A002

Sources: Haver Analytics and Bloomberg.Note: 1/ EA: 5y5y swaps; Japan QE2: 8–10 years ahead, 1MMA, based on inflation swap bid and ask points; UK: 5-year implied forward rate; US: Professional Forecasters median over next 5 years. 2/ UK’s inflation-indexed bonds are based on the RPI inflation, which typically runs higher than CPI inflation.

Credit channel (Figures 8 and 9)

Figure 8.
Figure 8.

Fragmentation

Citation: IMF Staff Country Reports 2015, 205; 10.5089/9781513523088.002.A002

Sources: Haver Analytics; Dealogic; Eurostat; ECB; and Fund staff calculations.Note: Core countries include DEU, FRA, NED. Selected countries include ESP, ITA, PRT.
Figure 9.
Figure 9.

Credit Developments

Citation: IMF Staff Country Reports 2015, 205; 10.5089/9781513523088.002.A002

Sources: European Central Bank; Haver Analytics; and Fund staff calculations.

16. Financial conditions have improved, while fragmentation has declined (Figure 8). QE has reduced wholesale funding costs as portfolio rebalancing effects have led to a compression of bank bond yields. 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 pre-crisis levels.

17. Credit constraints have eased (Figure 9). 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. Furthermore, with declining corporate bond yields, overall borrowing costs for firms have also fallen. Nevertheless, low inflation continues to keep real rates high affecting in particular more indebted countries.

A02ufig12

Impact of Expanded APP on Bank Lending Conditions

(Net percentage of respondents)

Citation: IMF Staff Country Reports 2015, 205; 10.5089/9781513523088.002.A002

Source: ECB.

18. 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 U.K. 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 will 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.

A02ufig13

NFC Debt Financing as of 2014

(Percent)

Citation: IMF Staff Country Reports 2015, 205; 10.5089/9781513523088.002.A002

Sources: National Central BanksNote: Debt includes bank loans and securities other than shares.1/ Japan debt financing data as of 2013.

19. However, credit recoveries after QE typically take more time. In Japan (2001) and the U.S. (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 (e.g., Japan (2010) and the UK (2009), mainly due to weak investment demand.

A02ufig14

Loans to Private Sector

(Indexed to time t = start of QE episodes)

Citation: IMF Staff Country Reports 2015, 205; 10.5089/9781513523088.002.A002

Sources: Haver Analytics; WB, WDI; IMF, WEO.Note: US; Commercial Bank Credit to the Private Sector; Japan; Domestic MFI Credit to the Private Sector; EA; MFI Loans to Private Sector; UK; M4 MFI sterling net lending to private non-financial corporations and households.

20. In the euro area, high NPLs remain an obstacle to a credit recovery. The ECB’s Comprehensive Assessment (CA) revealed high NPLs in several banking systems, with considerable variation among countries. High NPLs result in lower profitability and tie up substantial amounts of capital that could otherwise be used for new lending (Aiyar and others 2015). 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 and credit demand.

A02ufig15

Euro Area: Non-Performing Loans

(Percent of total loans)

Citation: IMF Staff Country Reports 2015, 205; 10.5089/9781513523088.002.A002

Source: IMF, Financial Soundness Indicators.

C. Simulations of Impact of QE and Spillovers6

21. To gauge the potential additional impact of QE through different channels, a few illustrative simulations are considered. The simulations were conducted using the Flexible System of Global Models (FSGM) in coordination with the IMF’s Research Department.7 Simulation outcomes are measured against the April 2015 WEO baseline, which already includes the impact of QE on term premia and asset prices. In the baseline, growth is projected to rise slightly from 0.8 percent in 2014 to 1.6 percent in 2016, supported by easier financial conditions and low oil prices. But with the still large output gap (2¼ percent of GDP), inflation is expected to remain low, close to zero this year and rising to only one percent in 2016.

22. Model simulations consider two scenarios of further depreciation and a faster recovery in credit. They feature (i) a further depreciation of the euro—2.5 percent in 2015—with a die-off rate of 50 percent; and (ii) a fully functioning credit channel—simulated as a decline in corporate borrowing rates—and an associated increase in inflation expectations.8

23. Further depreciation would increase growth initially through net exports and later through domestic demand. Growth initially is almost entirely driven by net exports, but by 2016 and 2017, domestic demand picks up, as higher export revenues feed into the domestic economy and higher inflation reduces real interest rates, increasing consumption and investment. As a result, the current account increases above the baseline in 2015, but converges back to the baseline in 2016. Inflation picks up, but remains below the price stability objective in 2017.9

24. In contrast, a better functioning credit channel and higher inflation expectations would support growth primarily through domestic demand. Lower lending rates and the increase in inflation expectations reduce real interest rates, stimulating both consumption and investment. Higher investment increases the capital stock, raising demand for labor, as well as increasing real wages. Rising income and wealth lead households to increase consumption further. As a result of stronger domestic demand, the current account declines below the baseline throughout the projection horizon. The larger capital stock increases potential growth, and inflation reaches the price stability objective by 2017. While a functioning credit channel is important for lifting domestic demand, a jump in inflation expectations is also important for supporting inflation and domestic demand by also helping to reduce real interest rates.

25. More open economies would benefit more from the depreciation, while countries with credit constraints would benefit more from an improved credit channel. For example, the initial growth impact of a further depreciation is larger for Germany, with a higher initial current account surplus, than for more closed economies such as France and Italy.10 On the other hand, Italy benefits more from a stronger credit channel and lower real rates. Inflation is sustainably higher in all countries.

26. Spillovers to the global economy are positive, particularly from higher domestic demand. Global GDP is above the baseline in both scenarios. Further euro depreciation initially hurts the euro area’s immediate neighbors and other advanced economies, but as domestic demand picks up negative spillovers diminish over time.11 Higher domestic demand in the euro area on the other hand would have immediate positive spillovers for most regions. However, the model captures mostly trade-related spillovers and does not take into account fully financial spillovers to other countries stemming from lower long-term yields.

A02ufig18

Global GDP

Citation: IMF Staff Country Reports 2015, 205; 10.5089/9781513523088.002.A002

A02ufig19

Other EU countries

Citation: IMF Staff Country Reports 2015, 205; 10.5089/9781513523088.002.A002

27. Empirical studies suggest that longer-term spillovers to neighboring countries are positive. In particular the pass-through from the euro area inflation rate to EE and some of the Nordic countries is relatively high (Arnold and others, 2015; Iossifov and Podpiera, 2014). As domestic demand and inflation in the euro area picks up, its neighbors are also likely to see higher inflation and greater demand for their products.

D. Implementation and Design of Asset Purchases

Addressing Potential Asset Scarcity

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

Table 1.

Overview of Asset Purchases under the PSPP

(as of June 30, 2015)

article image
Sources: Bloomberg L.P., ECB, and IMF staff calculations.Note:

including estimated net issuance until end-2016 and current SMP holdings (where applicable), after application of security issue and issuer limits;

excluding 12 percent of supranational debt purchases;

excluding Greece and Cyprus, adjusted for supranational purchases.

29. The potential scarcity of sovereign bonds may pose challenges for implementation. Staff analysis suggests that based on current trends, some NCBs might have difficulty meeting their target purchases due to the combined effect of the price cap on purchases (i.e., no purchase of securities with a yield less than 0.2 percent below the deposit rate), 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 (Annex 2). 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 (rather than nominal) amounts (which 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 higher price premium). However, for some countries, even lower (implied) nominal target volumes come very close to the maximum eligible amount after applying nominal limits (Figure 4).

  • 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 five percent of the eligible stock) (Figure 4). A shrinking target market enhances the effectiveness of portfolio rebalancing (Section B above) 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 minus 0.2 percent deposit rate reduces the pool of eligible sovereign assets subject to changes in market prices (Figure 2). 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 (Figure 2).

  • The scope for substitute purchases by NCBs is limited. The shrinking pool of eligible securities raises the importance of other (eligible) non-government debt securities, such as agency and supranational debt (Annex 2).12 However, the list of eligible agency debt remains restrictive even after recent amendments, suggesting a possible constraint on agency purchases in non-core countries. With approval from the Governing Council (GC), substitute purchases could also include other national public non-financial entities which are not currently eligible, and EU agencies.13 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.14

    A02ufig20

    Euro Area: Bank Holdings of Government Debt

    (Percent)

    Citation: IMF Staff Country Reports 2015, 205; 10.5089/9781513523088.002.A002

  • Weighting asset purchases by nominal outstanding amounts along the term structure shifts purchases towards longer maturities. Since the market value of longer-dated bonds is on average higher than that of shorter-dated bonds, this implies a greater share of purchases of longer-dated securities in market value terms. However, banks’ asset holdings decline dramatically beyond maturities beyond 10 years (chart below), and especially so in the more stressed 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 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. Non-bank 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 (next figure right). Regulatory requirements, such as asset-liability matching, and accounting standards, such as hold-to-maturity valuation, discourage them from selling debt securities. In addition, rising re-investment 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 2), limiting their incentive to sell. At the same time, incentives to sell sovereign debt and re-invest 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.

Improving Collateral Availability

30. Sovereign debt purchases may also impair market functioning (so-called financial “plumbing”) if they significantly diminish the availability of debt securities for securities lending. Eurosystem assets purchased are also valued by market participants for their collateral services (Cœuré, 2015; Singh, 2014). As opposed to the order-book15 model of price formation in equity markets, government bond markets are mostly over-the-counter (OTC) 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 (SFTs), i.e., repos and securities lending. Most government debt securities serve as liquid, fixed-duration and high-quality collateral for these activities.

31. 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.16 In addition, 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. Recent 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, and is expected to further contract (Figure 4).

32. The importance of the Eurosystem’s securities lending activities varies across countries. Similar to portfolio rebalancing, 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:

  • Small supply of collateral in the core economies. Banks, which tend to be more active lenders of collateral (Figure 4), 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;17 instead, much like in Eurosystem’s securities lending, they are likely to prefer lending out government bonds in return for other government bonds in high demand (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 non-domestic government debt as collateral, preventing a net release of highly sought-after collateral, such as German government debt by the Deutsche Bundesbank.

  • Greater liquidity among banks in countries outside the core. Negative deposit rates reduce incentives for banks to hold excess liquidity and encourage lending (or investment). For instance, in the case of Italy and Spain, the amount of government debt securities held by domestic investors has risen substantially since 2011—over 60 percent by end-2014. In addition, most investment securities held by euro area banks are valued on either a mark-to-market or fair value basis (for trading or assets for sale, respectively), with generally less than 20 percent being held to maturity, suggesting strong incentives for asset disposal or securities lending when interest rates decline. This also 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 (e.g., more than 80 percent of government debt holdings of European banks have a residual maturity of less than 10 years) (Figure 2), and are less likely to engage in securities lending at longer maturity tenors. Moreover, non-bank 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 either barred (or discouraged) from engaging in securities lending and liquidity swaps with banks (or asset managers). Similarly, high (foreign) official sector holdings of government debt of some core economies (outside the Eurosystem) remove collateral from securities lending within the euro area.

33. Based on these considerations, current securities lending by NCBs might be insufficient.18 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 1). 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 the securities lending remains decentralized under NCBs. Most of the current stock of PSPP (80 percent) is held by NCBs, whose securities lending is marked by considerable cross-country variation in conditions on pricing, haircuts, and eligibility.

34. 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 (Annex 2), which excludes market-makers who often use these assets when borrowing securities.19

E. Conclusion and Policy Recommendations

35. 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 GC should look through current market volatility and transient changes in inflation in signaling its monetary policy stance. Continued clear communication of the GC’s intentions will help mitigate excessive market volatility and reinforce its commitment to meeting the price stability objective.

36. 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.

37. 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 2),20 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 program. 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 with specialized securities lending agents for all NCBs21 (e.g., joint securities lending with specialized agents and coordinated by the ECB) to improve transparency, pricing, and the availability of collateral for market-making, supporting sufficient market liquidity (Figure 3).22 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 non-domestic 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.

Table 2.

Detailed Analysis of Target Market under the PSPP

(as of May 8, 2015)

ECB Public Sector Asset Purchase Program (PSPP)

(nominal amounts, EUR billion)

article image
Source: Bloomberg L.P., ECB, and IMF stafff calculations.Note:

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

considers net issuance, subject to issue/issuer limits (incl. SMP) 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 supranational debt are conducted by NCBs (without risk-sharing).

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Annex I. Securities Lending under the Expanded Asset Purchase Program (APP)

On April 2, 2015, the ECB and several Eurosystem NCBs began making available securities purchased under the PSPP and asset holdings under the securities market program (SMP). 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,” i.e., 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 bps for one week (which can be rolled over up to three times at an incremental cost of 10 bps 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 non-cash repo at a collateral haircut of four percent (which is shown the stylized model of securities lending in Figure 3 below), and 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, offering potential pricing benefit in an environment of continued spread compression. This should support collateral rates in selected economies (i.e., for instance as a result of swapping five-year German Bunds against a 30-year Italian treasury bond) and might also contribute to a 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 APP.

  • Decentralized securities lending. The Eurosystem NCBs, which complete most of the purchases under the PSPP, 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 are planning to make their securities available in Euroclear’s automated securities lending and borrowing program (SLB) 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 (i.e., NCBs will require a negative spread on the general collateral (GC) rate), which are influenced by market conditions.1 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, term and counterparty eligibility.2

A02ufig21

The Mechanics of Securities Lending

Citation: IMF Staff Country Reports 2015, 205; 10.5089/9781513523088.002.A002

Security lenders are not leveraged and lend for incremental revenue opportunities to improve portfolio yields. Bonds are only lent if they have value (“special”), i.e., there is a credit spread or the security borrower engages in maturity transformation (e.g., through collateral/“term upgrade” trades).

Securities lent are collateralized with:

  • Non-cash collateral—Bonds borrowed cannot be collateralized with cash but require collateral that complies with the beneficial owner’s stipulations (e.g. securities).

  • Cash collateral—Bonds borrowed can be collateralized with cash, which the securities lender can re-invest in repo or non-repo instruments. Due to the low interest rate environment, cash collateral is not attractive given the paucity of attractive investments.

Annex II. The Expanded Asset Purchase Program (APP)

The expanded asset purchase program (APP) was announced on January 22 and started on March 9, 2015; 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 securities purchase program (PSPP) represents about 80 percent of the volume generation under the APP. It 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 located in the euro area and complements existing purchases of covered bonds and asset-backed securities (under the CBPP3 and ABSPP). Purchases of government debt under the PSPP are conducted by both the ECB and national central banks (NCBs) 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”).

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 (i.e., stock under the Securities Markets Program) and any other portfolios owned by Eurosystem central banks.

A02ufig22

Overview of the Expanded Asset Purchase Program (APP)

Citation: IMF Staff Country Reports 2015, 205; 10.5089/9781513523088.002.A002

Note: *) empirically derived based on settled purchases as of June 7, 2015. 1/ via 4 European and 1 international asset management companies.

The general eligibility of assets for Eurosystem purchases under the APP is governed by the collateral standards defined for risk mitigation. Thus, Greek and Cypriot debt are currently excluded from purchases. Public sector securities in Greece are no longer eligible collateral for regular ECB refinancing operations after the conditions for the suspension of the minimum rating threshold for marketable debt instruments issued or fully guaranteed by the Hellenic Republic no longer applied (and as long as potential purchases would breach the current issuer limit of 33 percent due to the ECB’s SMP holdings of Greek debt). In the case of Cyprus, securities are not eligible until the successful completion of the program (or during a new review period once the last review has been concluded).

1

Prepared by S. Pelin Berkmen and Andreas (Andy) Jobst, with contributions from Benjamin Hunt, Suzanna Mursula, Dirk Muir (all RES) and research support from Jesse Siminitz.

2

This implies a nominal volume of asset purchases of €672 billion at current market prices (as of end-April 2015).

3

Selected countries include Ireland, Italy, Portugal, and Spain.

4

The size-weighted average maturity of Eurosystem holdings under the PSPP was 8.3 years after two months of purchases (Table 1 below).

5

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.

6

Simulations were provided by B. Hunt, S. Mursula, and D. Muir (all RES).

7

FSGM is a multi-region, forward-looking semi-structural model. Some key elements, like private consumption and investment, have micro-foundations, with others, such as trade, labor supply, and inflation, have reduced-form representations. Supply is determined by an aggregate Cobb-Douglas production function; and monetary and fiscal policies are endogenously set with simple rules (Andrle and others, 2015).

8

This would approximately correspond to a 3¼ percent shock in a quarterly model with a die-off rate of 85 percent. Corporate borrowing rates were reduced by 80 basis points in Italy, 25 basis points in Germany and France, and 50 basis points in the rest of the euro area. These would roughly reduce the current spread between selected and core countries to pre-crisis levels. The reduction in core countries captures higher lending due to an overall decline in the risk premium and other non-price effects. The change in inflation expectations is modeled as an exogenous 25 basis points increase, and after transmission through the model with nominal interest rates held fixed, leads to a reduction in real interest rates of about 40–50 basis points.

9

The large uncertainty around the exact impact of an REER shock reflects various factors, including sectoral shifts and structural reforms after the crisis, affecting both openness and trade elasticities.

10

The model’s short-run real competitiveness index elasticities for real exports are −0.21 for Germany and Italy, and −0.18 for France and the rest of the euro area. The European Commission’s research suggests that trade elasticities may be higher in some southern economies such as Italy and Spain, which would increase benefits accruing to these countries from further depreciation.

11

Foreign demand is a more important determinant of exports than the exchange rate both in the model and empirical studies.

12

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.

13

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

14

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

15

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.

16

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.

17

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 (GC) repos on German and French government bonds, which trade at spreads of more than minus 20 bps to the 12-month EONIA rate (Figure 2)).

18

Other major central banks that have completed a QE program adopted a centralized and active securities lending program. The U.S. Federal Reserve used the System Open Market Accounts (SOMA) Program (http://www.newyorkfed.org/markets/soma/sysopen_accholdings.html) (of up to 90 percent per issue). The Bank of England (BoE) adopted a three-stage process of lending to market counterparts, which comprised (i) direct lending by the H.M. Treasury’s DMO of own inventory, (ii) the BoE’s Standard Repo Facility (since 2009) if the DMO’s inventory is exhausted, and (iii) the BoE would make a portion of their purchases available to the DMO for lending with a negotiated borrowing fee. The Bank of Japan lent JGBs via auction-based repo agreements (using the New Gensaki trade type) to provide a temporary and secondary source of JGBs to the market to enhance liquidity.

19

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

20

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

21

This approach would ideally be supplemented with accessing the lending infrastructure of international central securities depositories (ICSDs). 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 (GMRA) Protocol to create legal certainty in NCB-sponsored securities lending.

22

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 limit on securities lending per issue, extend standard maturity terms (or reducing the extra charge for rollovers), and accept equity as non-cash collateral.

1

While EONIA and 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 20bps below EONIA (Figure 2).

Same Series

Other IMF Content

Other Publishers

Cover IMF Staff Country Reports
Euro Area Policies: Selected Issues
Author: International Monetary Fund. European Dept.
Volume/Issue:
Volume 2015: Issue 205
Publisher:
International Monetary Fund
ISBN:
9781513523088
ISSN:
1934-7685
Pages:
112
DOI:
https://doi.org/10.5089/9781513523088.002

Monitoring the Aggregate Effect of Sovereign QE (Financial Sector)

(as of June 22, 2015)

Size of Target Market and Maturity Term of Purchase under PSPP

(as of June 15, 2015)

Solutions for Active Securities Lending

Monitoring Sovereign QE

Monitoring Sovereign QE

Monitoring Sovereign QE

Portfolio Rebalancing and Signaling Effects

Eonia

(Effective Yield (bps), since Sep. 2014)

Change in Term Spread

(bps)

Sovereign Yield Curves

(Percent, last day of previous month of QE)

Investor base of Euro Area Government Debt Securities at the start of the QE Episodes

(Percent of total)

Euro Share in Foreign Exchange Reserves

Stock Market Index

(Index, 2009=100)

Household Total Assets

(Percent of total assets and debt)

Exchange Rate Effects

Nominal Exchange Rates

Openness Excluding Intra-EA Trade

(Percent GDP)

Inflation Expectations and Confidence

Euro Area: Inflation-linked Swap Rates

(Percent)

Medium to Long-term Inflation Expectations 1/

(Percent; YoY inflation rates; time t = QE episodes)

Fragmentation

Credit Developments

Impact of Expanded APP on Bank Lending Conditions

(Net percentage of respondents)

NFC Debt Financing as of 2014

(Percent)

Loans to Private Sector

(Indexed to time t = start of QE episodes)

Euro Area: Non-Performing Loans

(Percent of total loans)

Global GDP

Other EU countries

Euro Area: Bank Holdings of Government Debt

(Percent)

The Mechanics of Securities Lending

Overview of the Expanded Asset Purchase Program (APP)