The European Central Bank might need to change the rules of the game if it wants to keep playing in the bond market.
President Mario Draghi’s 1.7 trillion-euro ($1.9 trillion) asset-purchase program is scheduled to end in just six months, but euro-area inflation is still weak and the full shock of the U.K.’s Brexit vote could be yet to come. If the ECB extends quantitative easing — as most economists surveyed by Bloomberg predict — policy makers may have to reconsider what they can buy.
When the Governing Council gathers on Wednesday for a two-day policy meeting, its self-imposed purchase restrictions are likely to be a focal point, even if no final decision is taken. Draghi said at the last gathering in July that officials have shown they can adjust QE when required, and that there should be no doubt they can stick to their pledge to keep spending 80 billion euros a month until March 2017 “and beyond if needed.” Here are the key options:
Option 1: Changing the Issue and Issuer Limits
Rule: The maximum share of any single public-sector security that euro-area central banks can hold — known as the issue limit — has already been raised to 33 percent from 25 percent for bonds without collective-action clauses. The cutoffs are to prevent the ECB from gaining the power to block any restructuring plans and to avoid it becoming a dominant investor. The 33 percent threshold also applies to the exposure to any one bond issuer.
Solution: Raising the issue limit on bonds without collective-action clauses should be “fairly uncontentious,” according to a note by HSBC Holdings Plc. Increasing the limits is the “most likely” choice and could come as early as Thursday, according to Bloomberg Intelligence economists. The issuer limit might also be increased.
Cons: The ECB could distort markets. It could also be viewed as financing government deficits — which is illegal under European Union law.
Option 2: Changing the Deposit-Rate Floor
Rule: The ECB must only buy debt with a yield higher than the deposit rate, currently minus 0.4 percent. The rule ensures that losses booked by the central bank when it buys negative-yielding debt are offset by the income gained from its deposit account.
Solution: Lowering or scrapping the minimum-yield requirement would be one of the easiest options to implement, according to Barclays Plc. In particular, it would increase the available pool of German bonds — two-thirds of those assets are now ineligible after concerns of a Brexit-led slowdown prompted investors to seek a haven for their cash.
Cons: National central banks — especially in Germany — would be knowingly making a loss on some of the bonds they buy. Still, that doesn’t necessarily imply losses at an aggregate level for either individual central banks or the Eurosystem.
Option 3: Changing the Capital Key
Rule: QE purchases are shared between the national central banks in line with the capital key, which is roughly equivalent to the relative size of each economy. It means that more than a quarter of the debt bought is German, 20 percent is French, and 17 percent is Italian.
Solution: The ECB could deviate from the capital key and link buying to the amount of outstanding debt. That would put off scarcity concerns in countries such as Germany. Accelerating purchases in the euro-area periphery could expand fiscal space and benefit the real economy, Goldman Sachs Group Inc. said in a note in August. The central bank has already made small moves in this direction, citing the program’s flexibility.
Cons: The move would favor securities issued by countries with the biggest debt pile — notably Italy, the third-largest debtor among developed economies after the U.S. and Japan — and so raise concerns over monetary financing. Bundesbank President Jens Weidmann said last month that moving away from the capital key risks blurring the line between monetary and fiscal policy.
Option 4: Expand Into New Asset Classes
Rule: The ECB’s asset-purchase program started with covered bonds and asset-backed securities, before expanding into fully fledged QE with the addition of sovereign debt and agency bonds. It has since expanded into regional debt and corporate bonds, and its list of eligible agency bonds has been expanded.
Solution: A bigger step would be to identify new asset classes — Karsten Junius at J Safra Sarasin suggests equities. Exchange Traded Funds might be one route.
Cons: Some asset classes could prove controversial. For example, buying bank bonds could conflict with the ECB’s role as supervisor. While equity investors might be thrilled at the idea of the institution following its Swiss or Japanese counterparts in buying stocks, a series of less substantial changes would probably prove easier to implement.
There are other technical changes that could enlarge the universe of eligible securities. The ECB could alter the rules on substitute purchases or buy longer and shorter-dated debt than the 2-year to 30-year maturities currently allowed. It might also come up with something completely new.
More than 80 percent of economists surveyed by Bloomberg say the ECB will extend QE, and a similar share predict it will tweak its purchasing rules. Almost half of respondents foresee action on Thursday, with almost all the rest predicting an announcement at the October or December meetings.
“Draghi risks disappointing the market if he doesn’t verbally indicate that something is going to come,” said Holger Sandte, chief European analyst at Nordea Markets in Copenhagen. “If we’re going into an easing package in December then he should prepare for that.”