Wednesday, January 21, 2015

21/1/2015: ECB QE: Risk-Sharing or Risk-Dumping?

My comment for Expresso (January 17, print edition page 12) on what to expect from ECB next.

Given the deflationary dynamics, including the 5y/5y swap at below 1.50 and the first negative reading since 2009, there is a strong pressure on ECB to act. Crucially, this pressure is directly link to the ECB mandate. Additional momentum pointing toward ECB adopting a much more pro-active stance this month comes from the euro area leading growth indicators. Ifo's Economic Climate for the Euro Area continued to deteriorate in the Q4 2014 and January Eurozone Economic Outlook points to effectively no improvement in growth prospects in Q1 2015 compared to Q4 2014. Eurocoin indicator showed similar dynamics for December 2014.

At this stage, even the ECB hawks are in agreement that some monetary easing action is required and most recent comments from the ECB Governing Council members strongly suggest that there is strong momentum toward adopting a sovereign bonds purchasing programme.

The question, therefore, has now shifted toward what form will such a programme take.

Indications are, the ECB will opt for a programme that will attempt to separate risk of default from market risks. Under such a programme, the risk of sovereign default will be vested with the National Central Bank (NCB) of the bonds-issuing country, while the ECB will carry the market pricing risks.

The problem is that such a programme will directly spread the risk of fragmentation from the private sector financial system to the Eurosystem as a whole. If the NCBs carry direct risks (in full or in part) relating to sovereign default, the entire Eurosystem will no longer act as a risk-sharing mechanism and will undermine the ECB position as a joint and several institution.

Another problem is that if risks are explicitly shared across the ECB and NCBs, the ECB will become a de facto preferred lender, with rights in excess of NCBs and, thus, above the markets participants. Any other arrangement will most likely constitute a fiscal financing and will violate the restrictions that prevent non-monetary financing.

These twin problems imply that, unless the ECB fully participates in risk sharing with the NCBs, the QE programme will risk inducing much greater risk of repricing in the 'peripheral' euro states and thus can lead to greater fragmentation in the markets.

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