ECB QE: another hurdle cleared

Transcription

1 Deutsche Bank Research Europe Economics Date 15 January 2015 ECB QE: another hurdle cleared Barbara Boettcher Research Analyst (+49) The ECJ news this week makes it easier for the ECB to act sooner and above all reduces the risk of the ECB having to compromise on QE design. The benign conclusions on OMT by the Advocate General (AG) mean the ECB is neither explicitly constrained nor struggling with ambiguities. The fact is, the ECJ news was as positive as it could have been. We were not expecting the ECJ to outlaw OMT, but the risk was the statement would contain enough qualifications to put the ECB on the defensive with sovereign QE design. In the end, the AG s conclusions did no such thing. Based on our reading of the AG s conclusions we see two key consequences for the design of QE. First, in its ruling on the OMT, the GCC stated that the ECB could not be pari passu. The AG disagreed. Indeed, our interpretation of the AG s conclusions is that the ECB does not have to be senior. If confirmed by the ECJ final ruling, this would be a positive for the design of public QE, in our opinion. Alexander Duering, CFA Strategist (+44) alexander.duering@db.com Marco Stringa, CFA Economist (+44) marco.stringa@db.com Mark Wall Chief Economist (+44) mark.wall@db.com Second, our view that the ECB will be constrained in buying no more than 25% of CAC bonds appears to have been confirmed by the Advocate General. To avoid introducing further distortion and the retroactive introduction of CACs, we think it is also likely that the ECB will use a similar cap on non-cac bonds. We show that an introduction of a cap will have consequence in terms of both the overall size of the QE programme and the distribution of the ECB purchases across countries. We suspect that the ECB internal limit will be lower than 25% as going too close to such a limit would potentially give a small group of investors a blocking minority. For this reason we now believe more likely that the ECB will buy beyond the 10Y maturity to comfortably reach its target balance sheet expansion. Furthermore, the lower the cap, the less relevant capital keys would become in terms of the composition of the ECB public QE portfolio. Indeed, the lower the cap, the greater would be the advantage for high debt/gdp countries. With the ECJ hurdles comfortably cleared, inflation breakeven rates tumbling and Benoit Coeure s dovish comments accumulating, QE feels a done deal. The consensus expectation is QE will be announced on 22 January. We continue to warn that ECB QE is complex and still controversial. The ECJ s green flag for pari passu purchases means compromise on seniority is not necessary. But there are other challenging design decisions, from country coverage to volumes to the location of risk. Timing might not be important. Even if we are right and a formal QE decision waits until March, Draghi has to send a clear signal on 22 January of imminent QE. But if we are wrong and a formal vote on QE happens in January, we think the full details are likely to wait until March. In our view, how the ECB implements public QE is more relevant than whether the official announcement occurs in January or March. Deutsche Bank AG/London DISCLOSURES AND ANALYST CERTIFICATIONS ARE LOCATED IN APPENDIX 1. MCI (P) 148/04/2014.

2 Introduction In this note, we provide our preliminary take on the ECJ Advocate General s considerations from an economic perspective 1. We discuss the ramifications for when and how the ECB conducts QE. In particular, we explore how an implicit cap on purchases of CAC bonds means the ECB will likely go further along the curve than the 10Y point. On 14 January, the ECJ Advocate General, Cruz Villalón, has concluded that OMT is in line with the EU Treaty and the mandate of the ECB but has suggested some conditions that OMT would have to satisfy. Some of these are also relevant for the design of public QE in our view. The opinion of the Advocate General can be taken as an indication for the final opinion of the ECJ. While the opinion is not binding for the judges, the Court tends to follow the opinion in the broad majority of cases (broadly speaking in up to 80% of all cases). However, even if the Court takes the same opinion, the ruling can differ in details that matter for the final impact of the ruling, in this case for the financial markets. Also, there are examples where the ruling of the Court overturned the legal advice given by the Advocate General. 2 The Advocate General s opinion, if confirmed, is a positive for an efficient design of QE in particular he rejected the view of the GCC that the ECB has to have seniority. What will the GCC do if the ECJ follows the Advocate General s opinion? We think that the GCC will tend to follow the ECJ s interpretation of Treaty. That said, a potential grey area is if the GCC sees more of an issue with the German Constitution. We may have to wait for the final ruling before obtaining full clarity. By then, we expect the public QE to have been fully implemented. Advocate General addressing the set of questions referred by the GCC The reasoning of the Advocate General followed the set of questions referred to the ECJ by the German Constitutional Court. He stressed that he had based his opinion on the statements by the ECB as there has never been a legal act to implement OMT. He thus considers that the ECB must give a proper account of the reasons for adopting an unconventional measure such as the OMT programme identifying clearly and precisely the extraordinary circumstances that justify the measure. He shared the GCC s view that a programme by the ECB must refrain from any direct involvement in the financial assistance programme that applies to the State concerned. He pointed out that the EU Treaty does not prohibit transactions on the secondary market but sufficient safeguards have to ensure that the intervention is not breaching the prohibition of monetary financing. 1 The deep legal consequences are beyond our remit. 2 One example with relevance for the financial markets was the case of banning short selling that was taken to the ECJ by the UK in May While the Advocate General saw no proper legal basis for the European Securities and Markets Authority (ESMA) to adopt such a provision the Court ruled that the power of ESMA would allow the agency to adopt such emergency measures on the financial markets of the Member States. Nonetheless, such a principle overruling of the Advocate General by the Court remains an exception. Page 2 Deutsche Bank AG/London

3 He said that the ECB will have to be cautious in implementing and executing its programme in order to prevent speculative behavior thus again supporting the GCC s view that price formation on the markets should not be massively distorted. In this context he observed that in order to comply with the prohibition of monetary financing, there needs to be a real difference between purchases of bonds on the primary market and the secondary market. Finally, he considered the OMT programme necessary as well as proportionate, since the ECB does not assume a risk that will necessarily make it vulnerable to insolvency. He took the view that pari passu clauses may be regarded as a means that seeks to ensure that the ECB disrupts the normal functioning of the markets as little as possible and refers to the ECB s written observation to the Court that in the context of a restructuring subject to CACs it will always vote against a full or partial waiver of its claims. We will come back to this in the below section as it is a crucial passage. The GCC could well read this that as turning down its concerns over the ECB s involvement in debt restructuring and the respective risk sharing. By assessing the implications of the legal opinion on OMT for the design of a public QE programme it should be remembered that the rationale behind the two programmes is different. The OMT was aimed at removing the irrational risk premia for some sovereign bonds stemming from an overall euro area break-up scenario. This led the GCC to ask whether the programme, rather than being a monetary policy measure to smooth the monetary transmission channel, is in fact an economic policy measure which would fall outside the scope of the ECB s mandate. Now, large-scale bond purchases such as public QE are aimed at meeting the ECB medium-term inflation target and hence anchoring inflation-expectations. Even after taking into account the conditions set out by the Advocate General, there seems to be no evidence to prevent a QE programme aimed at loosening monetary policy across the euro area. Indeed, the Advocate General emphasized that the ECB must have broad discretion when framing and implementing the EU s monetary policy, and the courts must exercise a considerable degree of caution when reviewing the ECB s activity, since they lack the expertise and experience which the ECB has in this area. Possible implications for the design of public QE We think the Advocate General s conclusions strengthened the position of those within the ECB who support public QE. In particular, we think that this week s development reduced the challenges the ECB faces to design QE. We see two key consequences for the design of QE: First, based on our interpretation of the Advocate General s conclusions, the ECB can be pari passu. Second, our view that the ECB will be constrained in buying no more than 25% of CAC bonds appears to have been confirmed by the Advocate General. To avoid introducing further distortion, we think it is also likely that the ECB will use a similar cap on non-cac bonds. In the next two sections we look in more detail at these two key issues for the design of QE in the euro-area. Note that the consequence of the implicit 25% cap would be material in terms of the interaction between size of QE and targeted maturities and also in terms of the proportion of bonds purchases across countries. The latter is becomes more evident if the ECB decides to remain significantly below the 25% cap. Deutsche Bank AG/London Page 3

4 First consequence: seniority does not appear necessary Based on its ruling on the OMT, the GCC in referring the case to the ECJ stated that the ECB could not be pari passu. The reasoning was that if the ECB and NCBs do not have the status of preferential creditor they may be obliged to accept a restructuring agreement, which would break the prohibition of no financing of a member State. Draghi had already indirectly responded by saying that the form of seniority will be chosen to minimize distortion. This week s development should significantly simplify his task. Indeed, based on our interpretation of the ECJ Advocate General s conclusions, the ECB does not have to be senior. If confirmed by the ECJ final ruling, this would be a positive for the design of public QE in our opinion. In particular, the Advocate General stated that he does not find convincing the necessity of being senior: In his view, the risk of a full or partial loss relates only to a hypothetical situation entailing the restructuring of a euro-area member State and is not an intrinsic component of the OMT design. He continued by stating that the assumption of risk is inherent in a central bank s activity, hence the potential materialization of the risk is not a necessary consequence of implementation of the programme. In our view this would be an outright positive for the design of QE in the euro-area The Advocate General stated that purchases by the ECB, as a nonpreferential creditor, will inevitably involve a degree of distortion of the market, which he sees as be tolerable from the point of view of the prohibition of monetary financing. By contrast, in his view purchases made with the status of preferential creditor would deter other investors. Hence, he continued: I take the view that pari passu clauses may be regarded as a means that seeks to ensure that the ECB disrupts the normal functioning of the market as little as possible, which, ultimately, involves a further guarantee of compliance with Article 123(1) TFEU. Overall we think the Advocate General has made a compelling case also from an economic point of view in favour of pari passu. Second consequence: a 25% cap on CAC bonds appear likely The Advocate General s opinion confirmed our intuition that the ECB must not agree to restructuring of sovereign debt that it holds. However, it would not be a breach of the EU Treaty if the ECB faces a restructuring against its will as such losses would not necessarily be considered monetary financing. With this clarification, the ECB can allow itself to be treated pari passu with other investors instead of creating effective subordination of the public market. However, this confirms our view that the ECB will be constrained in buying no more than 25% of CAC (Collective Action Clause) bonds. In discussing his reasoning on why the ECB can be pari passu, the Advocate General highlighted that the ECB has stated in its written observations that, in the context of a restructuring subject to CACs, it will always vote against a full or partial waiver of its claims. In other words, the ECB will not actively contribute to bringing about a restructuring but will seek to recover in full the claim securitised on the bond. Given that we see the ECB will not want to prevent orderly debt restructurings at any cost, the ECB can satisfy the above commitment of voting against a Page 4 Deutsche Bank AG/London

5 restructuring by capping its purchases of any CAC bond issuance to 25% of outstanding amount. In this case they will be below the blocking minority of a CAC. Note that from the perspective of the good function of the euro-area sovereign bond market the benefit to the ECB to be pari passu is comparable to the benefit of maintaining the possibility of orderly restructurings. If the ECB is senior, loss-given-defaults for other investors increase with ECB buying in case of default. Similarly if the ECB is pari passu but owns a blocking minority and must never agree to a restructuring, loss-given-defaults become more difficult to predict. Probably they would increase as restructurings would become more chaotic. To avoid introducing further distortions, we think that it is likely that the ECB will use a similar cap also on non-cac bonds. Further, given the Greek experience where CACs were introduced retroactively we would logically expect the ECB to assume the same for all other countries and hence they would like to limit their purchase to 25% at most for all bonds and not just bonds with CACs. (I) - Consequence of CAC/non-CAC caps on QE size and maturities On the face of it, a 25%-cap might not seem a large constraint. There is well over EUR 6trn of sovereign long-term debt available in the euro-area, permitting purchases of 1.5tr under this constraint. This is far in excess of what would currently be considered a realistic balance sheet expansion target for such operations. However, we believe that the ECB will at the same time look to observe a country distribution that is close to the ECB capital keys. We therefore assume that the ECB would apply both the capital key constraint and the 25% limit simultaneously. In addition, monetary policy and market consideration to avoid excessive distortions should create maturity constraints. This would lead to addition quantitative constraints via the limited outstanding bonds in each maturity bucket. Overall, applying all limits cap, capital keys and maturities at the same time reduces the amount of debt that the ECB could be willing to buy as shown in Figure 1 (we use data as of 15 January). Figure 1: Theoretical max QE size as a function of cap and maturities (EUR bn) Targeted maturity 3Y-10Y 2Y-15Y 1Y-30Y Cap on CAC and non-cac bonds (%) Source: Deutsche Bank The ECJ conclusion implies that the ECB won t purchase more than 25% of CAC and non-cac bonds. We suspect that their internal limit likely to remain unpublished will be lower. This is because the ECB may be reluctant to go to close to the 25% cap for each individual issuance as a small group of investors Deutsche Bank AG/London Page 5

6 could build a blocking minority. That would reduce the probability of an orderly restructuring. For this reason we now believe more likely that the ECB will buy beyond the 10Y point. Note that based our indicative estimates a cap of 20% on 2Y-15Y government bonds would imply total potential purchase of almost EUR 800bn. This is 60% more than the EUR 500bn often mentioned by the press. Recall, however, the ECB QE programme encompasses several assets; on balance we think it is more likely than note that they will also include corporate bonds. The ECB could meet its overall target without going significantly above EUR 500bn of government bond purchase. Note, however, that the above table does not include European supranational institutions, government guaranteed debt and other quasi-government institutions. If these bonds were to be included by the ECB, then a narrower maturity target could suffice. The concern that speculators might buy stakes in bonds where together with the ECB (who is forced to be a holdout) they can form a blocking minority in case of a CAC activation will not only affect the internal cap on purchases that the ECB will apply. It is likely to also influence the ECB s publication of investments. While the Bank of Japan and Bank of England break down security holdings to individual bonds, the ECB is more likely to withhold that information. 3 Looking at the long term, it is in any case interesting that even a moderately large programme of EUR 1trn would requires rather aggressive maturity limits. We think that QE would have to become a less unconventional and hence less controversial tool in the euro area monetary policy. Indeed, this is not going to be the last time the ECB will need to implement QE to meet its medium-term inflation target in our view. (II) - Consequence of CAC/non-CAC caps across countries The above analysis can also provide a broad indication of the amount purchase across countries based on the above three constraints: cap, capital keys and maturities. Our key conclusions are that: For high-debt countries, the capital key constraint is likely to be binding, while for low-debt countries the 25% limit is likely to be binding. The lower the cap, the less relevant capital keys would de-facto become in terms of the composition of the ECB public QE portfolio. The ECB exposure would become increasingly linked to the absolute size of outstanding government debt markets as the size of the programme increases. In other words. The lower the cap, the greater would be the advantage for high debt/gdp countries. The estimates supporting the above two points are summarized in Figure 2 overleaf. 3 The ECB might not publish the amounts it holds of each individual security, it is still likely to report aggregate amounts for each country. In this way, investors looking to build blocking majorities on the back of ECB purchases would not know which security to target, at least not in larger countries with a large number of outstanding bonds. The ECB would for this reason also prefer to target a wide maturity range so as to be able to keep the actual holding of each bond well below the cap. Page 6 Deutsche Bank AG/London

7 Figure 2: Indicative final portfolio composition of an ECB QE programme based on different cap (15%, 20%, 25%) and QE targeted size ( 500bn vs 1trn) Panel A: Big 4 in a 500bn public QE programme Indicative proportions bought across countries (%) in a 500 bn public QE programme 30 Rescaled 25 capital keys Germany Spain France Italy cap = 15% cap = 20% cap = 25% Panel B: Big 4 in a 1trn public QE programme Indicative proportions bought across countries (%) in a 1trn public QE programme 30 Rescaled 25 capital keys Germany Spain France Italy cap = 15% cap = 20% cap = 25% Panel C:Indicative composition across all euro-area countries Re-scaled Implicit cap = Implicit cap = Implicit cap = capital 15% 20% 25% keys Target = EUR 500bn Target = EUR 1000bn Target = EUR 500bn Target = EUR 1000bn Target = EUR 500bn Target = EUR 1000bn % % % % % % % Belgium Germany Estonia Ireland Greece Spain France Italy Cyprus Latvia Lithuania Luxembourg Malta Netherlands Austria Portugal Slovenia Slovakia Finland Total Source: Deutsche Bank, ECB Public QE: How is more important than when In our view, the ECJ news this week makes it easier for the ECB to act sooner and above all reduces the risk of the ECB having to compromise on QE design. The ECB did not just pass another event on the road to QE. The benign conclusions on OMT by the Advocate General mean the ECB is neither explicitly constrained nor struggling to read between the lines of an ambiguous statement. The fact is, the ECJ news this week was as positive as it could have been. We were not expecting the ECJ to outlaw OMT, but the risk was the statement would contain enough qualifications to put the ECB on the defensive with sovereign QE design. In the end, the AG s conclusions did no such thing. From a legal perspective and assuming the European judges don t disagree with their final ruling around mid-year the door to sovereign QE appears wide open, even more so than we had hoped. There is some risk that the judges, or even the German Constitutional Court, take a different view, in whole or in part. But the ECB won t wait for either, in our view. The view that pari passu QE is not inconsistent with the Treaty is the most significant news. There was no uncertainty in the mind of the AG. Buying a bond and accepting a loss are two separate events. The first does not, in and of Deutsche Bank AG/London Page 7

8 itself, imply the latter. This saves the ECB the difficulty (impossibility) of maintaining seniority and avoiding market distortion. This does not rule out other compromises, but mostly for political rather than legal purposes. For example, it probably suits the Council to organize the purchasing at an NCB level. This will make it look like the risk is being held at a local level. One cannot be confident of being able to isolate all QE risk at the national level. Depending on the location of the seller relative to the NCB doing the buying and the spillover flows triggered by QE, Target2 imbalances can be affected (if QE boosts confidence and triggers inflows, it is even possible Target2 imbalances improve). In any case, the statutes say the ECB can indemnify NCBs against losses on monetary policy operations. Figure 3: 5Y5Y inflation rate has continued to declined HICPxt swap 5y5y TLTRO announced ABS/CBPP announced Jackson Hole speech Dovish November 1.50 press conf Jan-14 Mar-14 May-14 Jul-14 Sep-14 Nov-14 Jan-15 Source: Deutsche Bank, Bloomberg Finance LP Beyond effectively bowing to ECB expertise in establishing monetary policy and clearly endorsing pari passu bond purchases, the other common thread through the AG s opinion was the need to avoid market distortions. One implication of the latter relates to limits. The AG felt an ex ante limit on OMT could create market distortions ( trigger speculation ). We hold our view that the ECB is unlikely to set explicit volumes targets this does not mean the ECB would not have (unpublished) internal targets. The question is whether the minimization of market distortions affects other elements of the design. For example, using outstanding debt levels to weight the purchases would be less distortionary than the Capital Key. Draghi needs to trade off distortions against political expediency, both inside and outside the Council. We continue to believe that for political purposes the principle of the Capital Key will underline the weighting. In any case, we showed above that the introduction of a cap blurs the line between using Capital Keys or outstanding debt levels. ECB sovereign QE is no longer a case of if, but when and how. It was already a close call. We have said we very marginally prefer March in terms of the timing of the formal decision on QE. But we acknowledge how the ECJ decision makes it easier for the Council to agree QE on 22 January. With seniority no longer at stake, there are fewer design complexities that take time to resolve. We could easily be wrong, but we are holding to the view that the official decision is implemented in March. There are other non-negligible design features that the ECJ has not helped resolve, for example, country coverage, in particular whether sub-investment grade countries should be included in this Page 8 Deutsche Bank AG/London

9 QE. Benoit Coeure has said the timing of the election does not affect the ECB decision. We do not know whether this is a majority view. Maybe the timing of the Greek election is a factor requiring a delay. As we said last week, timing might not be important in any case. To avoid market disappointment, we expect Draghi to send a clear signal on 22 January of imminent QE. He could say there is a majority or broad consensus for changing the composition of asset purchases and that it will include sovereign bonds -- but that the formal vote awaits the final input on design of the staff committees in March. Even if we are wrong and a formal vote happens on 22 January, we think the full implementation is likely to wait until March in any case. How the ECB implements public QE is more relevant than the timing of the formal decision. Last week, we stated our expectation for QE as the following: a broad-based asset purchase programme, encompassing investment grade corporate bonds as well as sovereign bonds; no target size to be set for the sovereign purchases; the ECB to conduct the purchasing over a two year period at least, in line with the ABS and covered bond purchases; the ECB to purchase the sovereign bonds of all member states in proportion to the Capital Key; sub-investment grade countries will need to be under a programme; and the bonds purchased to go beyond the OMT limit of three years but not beyond ten years 4. The only change we have made since last week is maturity. Assuming the ECB seeks to minimize distortions by imposing a cap well below the 25% level on CAC and non-cac bonds, the ECB would have to go beyond the 10Y point to access a sufficiently large set of bonds. Outlook and timeline for the final ECJ and GCC proceedings Following the delivery of the legal opinion of the Advocate General a Judge- Rapporteur (in this case: Vice-President Koen Lenaerts) will draft a judgment. Given the importance of the case, the Court will sit in a Grand Chamber of 15 Judges and deliberate on the draft judgement. Each of the Judges may propose changes. The decision of the Court is taken by majority but no record is made public of any dissenting view. Usually it takes between three to six months between the delivery of the legal opinion and the judgment of the Court. However, given the importance of the case and its implicit relevance for the design of the ECB s sovereign bond purchasing programme we expect the reply by the ECJ to come earlier than the usual gap. The case would then go back to the GCC which has originally opened the preliminary ruling procedure at the ECJ. As it has been the first time in history that the GCC has referred a case to the ECJ the Advocate General seized the occasion to elaborate on the relationship between the ECJ and the national constitutional courts, in particular the GCC. This is not of minor importance as there is a largely undefined relationship between the GCC and its European counterpart. While the GCC in principle should be bound to an ECJ interpretation of the EU Treaties, the GCC has expressly reserved the right to form its own views should it consider actions taken to entail a structurally significant shift in the allocation of powers to the detriment of the Member States (so-called Honeywell decision of 2010). While acknowledging the constitutional reasons the GCC is citing for its position, the Advocate General sees the ECJ in the lead of interpreting the European laws. He thus expects the GCC to accept the (preliminary) answer by the Court as decisive for the GCC proceedings in order to allow a consistent interpretation of European laws. 4 See ECB QE: From if to when and how, Focus Europe, 9 January Deutsche Bank AG/London Page 9

10 Given the pronouncement of the GCC when it referred the case to the ECJ ( subject to the interpretation of the Court of Justice ) the GCC seems prepared to take the ECJ ruling as the foundation for its judgement. The ruling of the GCC can be expected around the end of the year but will most probably not be the end of the road. Some of the plaintiffs will probably launch further complaints in the context of the ECB s non-conventional monetary policy - all the more as the Advocate General mentioned multiple times that details matter in implementing such a programme. Page 10 Deutsche Bank AG/London

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