European QE: what it all means

Mario Draghi Some economists say the ECB and national central banks could end up spending more than 2 trillion euros. Photo: Sean Gallup

Mario Draghi

Mario Draghi

ECB launches €1.1 trillion rescue plan

The European Central Bank has announced a quantitative easing  (QE), or asset-buying, programme worth an initial 1.1 trillion euro. The much-anticipated plan is aimed at heading off deflationary pressures and stimulating growth across the eurozone. The program will involve mainly the purchase of government bonds using freshly-printed money.

How does it work?

In March, the ECB and national central banks of euro zone member states will start buying 60 billion euros of private and public sector debt each month. Of this, 50 billion euros will be spent on sovereign and European Union agency bonds, and 10 billion euros on repackaged private debt such as asset-backed securities and covered bonds, which are bank mortgages. Of the state debt allocation, 12 per cent will go towards bonds issued by the European Investment Bank and other EU agencies such as the European Stability Mechanism and the European Financial Stability Facility. A further 8 per cent will be accounted for by direct ECB buying of government bonds. The remaining 80 per cent of sovereign debt purchases will be by national central banks of bonds issued by the government of that country.They will carry the risk of default.

What are the rules?

Bonds rated BBB- and above qualify. Anything below this quality level are deemed “junk” or high-yield and do not qualify. A maximum of 33 per cent of the bonds issued by any one country may be bought. This means that Greece would not qualify for now because the ECB and other euro zone central banks already own more than this amount, after a bail-out of the country with the International Monetary Fund in 2010. In any case, exception would have to be made for any further purchase of Greek sovereign debt because of its low grade.

How long will the ECB’s QE last?

The initial plan is to buy bonds until September 2016 or until there has been a “sustained” improvement in consumer price inflation, which recently turned negative. The ECB’s official inflation target is 2 per cent. The program could end earlier if successful, or be extended if its impact is small. Some economists say the ECB and national central banks could end up spending more than 2 trillion euros.

What’s the point of QE?

The European economy is in a rut. Unemployment is high, growth is weak and inflation is dangerously low. The low inflation trap is especially pernicious, prompting consumers to delay purchases and companies to put off investment. If it worsens, Europe could face the widespread decline in prices known as deflation, which hurts companies’ profits and leads to more unemployment. Once deflation grips an economy, it is very difficult to escape. Japan has been trying to break the cycle for more than two decades. In such an environment, central banks usually cut interest rates. But the ECB has already lowered its benchmark rate to almost zero. It has even imposed a negative interest rate on bank deposits held at the central bank. The ECB has also been lending more money to commercial banks at rock bottom rates. But demand from banks has been tepid.So quantitative easing is the next logical step – and perhaps the central bank’s only option.

How does QE work?

By buying bonds directly from issuers and financial market investors, the ECB and national central banks keep bond prices high and yields low. This guarantees companies, governments and households low financing rates over the long term. It also frees up money for investment in higher-risk assets such as shares, property and business expansion, which can help re-inflate economies as activity heats up. Low short- and long-term bond rates will also keep the euro low, which should make the EU more competitive in its exports and against imports.

But will it work?

The most important effect of quantitative easing might be psychological. By demonstrating that it is serious about stoking inflation, the ECB could prevent people from adopting a mind-set where they think prices will continue to fall. This is why Mario Draghi, the central bank president, and other top central bankers talk a lot about “inflation expectations”. Another benefit would be the weaker currency, although a lot of EU trade is conducted with itself, and export demand from outside the common currency area remains weak. As to QE’s objective of stimulating borrowing, this is unlikely to be as effective as in the United States, where companies regularly tap the corporate bond market for financing. European companies, by contrast usually get credit from banks. Although banks have, and will, benefit from QE, demand for bank credit from companies and households has been weak – most have been focused on paying down debt and consolidating since the global financial crisis. There are also those who say that QE is only effective when the capital markets cease to function, as they did during the the GFC. This is not the case now, so ECB QE may be too little, too late.

How will ECB QE affect Australia?

The most obvious and immediate impact is on currency trading – note the commotion set off when the Swiss National Bank gave up trying to hold down its currency against the ever-weakening euro. Despite the doubts, currency can be an important weapon in the battle for a share of global trade. The lower a country’s currency against that of its competitors, the cheaper its exports. Also, competing imports become more expensive, helping high-cost domestic producers. ECB QE could encourage other central banks, including the Reserve Bank of Australia, to ease monetary policy to keep the Australian dollar competitive, although this will depend on the performance of the domestic economy and what happens elsewhere. For example, the Canadian central bank’s decision this week to cut interest rates could be more influential when the the RBA next meets to discuss policy. With European bond yields likely to stay low for longer, the yield on Australian bonds again looks attractive to investors, not only in Europe but in countries with large savings pools such as Japan. This search for yield can work against attempts to keep the currency low. Share markets – including the Australian Stock Exchange – normally get a boost  from QE announcements and money-printing because they result in new money looking for returns away from bond markets.

with agencies