The Governing Council of the European Central Bank decided to start monthly asset purchases of 60 billion euros from March 2015. From April 2016 the average monthly purchase volume has been 80 billion euros. It is planned that the monthly purchases will be made until March 2017, but they will certainly continue until a lasting correction in inflation is apparent that will fit with the task of the European Central Bank of keeping inflation below but close to 2% over the medium term. The assets purchased are bonds issued by governments of the euro area and European institutions, and investment-grade euro-denominated bonds issued by non-bank corporations established in the euro area. Of the current programmes, the purchases of covered bonds and asset backed securities will continue.
What is the aim of the programme?
The asset purchase programme helps the European Central Bank in its task of keeping inflation below but close to 2% over the medium term. Asset purchases can provide an additional stimulus to an economy if the traditional monetary policy tools of a central bank are becoming exhausted because it is already lending to commercial banks at interest rates close to zero. Asset purchases push the yield on euro area central bank bonds down and this induces investors to put their money elsewhere, which should improve the financing options available to companies and households. This should encourage investment and consumption in the euro area and ultimately help boost inflation towards 2%.
What type of bonds are purchased?
The purchases that started in September last year of covered bonds and asset backed securities are continuing. The monthly purchases under these two programmes have been worth around 8–10 billion euros. In January the Governing Council of the European Central Bank decided to start buying bonds issued by euro area governments and European institutions with maturities of 2–30 years. From June this year the programme was extended to include purchases of bonds issued by euro area companies other than banks. The expanded monthly asset purchases of the euro area central banks under the three programmes will remain in the order of 80 billion euros.
How are the bonds purchased?
The European Central Bank and national central banks buy the assets. As this is a monetary policy measure, the money for the purchases is issued by the central banks.
The national central banks divide the purchases amongst themselves using the European Central Bank capital key. Estonia’s capital key is 0.274%.
Is it only sovereign bonds that are purchased?
The euro area central banks generally buy sovereign bonds from their own country, but the bond issues of some smaller countries and the volumes of their bonds on the market are limited, while the Estonian government has not issued any bonds at all. In these cases the national central banks make alternative purchases, usually by buying bonds from international institutions like the ESM or the EFSF. From June 2015 to May 2016, Eesti Pank had a special exemption allowing it to buy the bonds of the state-owned transmission system operator Elering. From June, the Finnish central bank has been able to buy bonds issued by Elering and Eesti Energia on behalf of the central banks of the euro area.
What limits are there on purchases of public sector bonds?
The main restriction is that central banks may only buy the sovereign bonds from the secondary market. In this case private investors have shown themselves ready to risk their own money, meaning that the risks and reasonable return of the bonds being bought have been accounted for. If the central banks were to buy the bonds directly from the governments, it would be a case of monetising of government debt, and that is prohibited for European central banks.
A second restriction is the limit on issuance, as euro area central banks may only buy up to 33% of one issue of bonds. This means that a central bank can only buy one third of each individual issue of government bonds from the secondary market. This limit applies to all the bonds bought by central banks of the euro area, including bonds that were purchased earlier.
A third restriction is a limit of 33% for each issuer. This means the central banks can only buy the 2–30 year bonds of those states where less than one third of all the bonds are held by central banks of the euro area.
Both limits apply to the nominal value of the bonds, meaning that a fall in the market price of the bonds does not make further purchases possible.
A fourth restriction says the central banks can only buy bonds that the central banks are usually prepared to accept as collateral when commercial banks take monetary policy loans. An exception is made for countries like Greece and Cyprus that have agreed a programme of assistance, and the bonds of those countries can only be bought if they comply with the terms of the programmes. While the assistance programmes are under review, bonds issued by those countries may not be purchased.
What limits are there on purchases of corporate bonds?
The central banks of the euro area can buy investment-grade bonds with a rating of at least BBB- or equivalent denominated in euros and issued by euro area companies other than banks, of the sort that the central banks of the euro area generally accept as collateral when a commercial bank takes a monetary policy loan from a central bank.
The same limits apply for purchases of bonds issued by public sector enterprises as for purchases of sovereign bonds (see above). There is a purchase limit of 70% of an issue of bonds for the bonds of private sector companies.
Bonds are purchased which have a remaining maturity at the moment of purchase of between six months and thirty years.
Bonds can be bought from the primary or secondary markets. Bonds of public sector enterprises are only bought from the secondary market following the same principles used for sovereign bonds.
How are the risks of the bonds to be divided?
The risks of the purchase programmes that started in September last year of covered bonds and asset backed securities are divided by the capital key of the European Central Bank, so Estonia has 0.274%. The risks of the purchase programme for corporate bonds are shared using the same principle.
It has been agreed that each national central bank is responsible for the risks of the sovereign bonds bought with its own balance sheet. The risks of the bonds of the pan-European institutions are shared between the central banks of the euro area in accordance with the capital key. The capital key is used in the same way to share out the risks from the purchases of the European Central Bank, as the national central banks of the euro area are all shareholders in the European Central Bank under the capital key.
Why are the risks not being pooled in full as usual?
Restricted pooling of risk reduces the theoretical risk of insolvency spilling over from one country to another because of debt mutualisation. This makes each national central bank more responsible for assessing the bonds it is buying.
Not pooling the risk also reinforces the responsibility of national governments for their own debt, as it is the job of each country to capitalise its own central bank. This means that if a central bank suffers a major loss from its purchases of bonds, its national government will have to supply it with additional capital.
The risks are also not being pooled because of the prohibition on central banks financing governments. If purchases of sovereign bonds by a central bank lead to a weakening of the government’s financial discipline, it would be a case of circumventing this prohibition. If the credit risks of the sovereign bonds of a particular euro area country remain with that country, there is less danger of financial discipline weakening and there is less chance of the ban on the financing of the government being breached.
Can the assets purchased be sold on before their maturity dates?
The Governing Council has not yet decided on the subsequent sale or not of the assets.
How will the large-scale purchase of government debt affect fiscal discipline?
Purchases of assets are no substitute for structural reform and they can only be used to boost economic activity over the short term. The purchases of government bonds lower borrowing costs for governments to some extent and so it has been easier for euro area governments to finance their spending in 2015 and 2016 by borrowing. This could lead to a loosening of fiscal policy and to structural reforms being postponed. To avoid this, it is extremely important that all the countries in the euro area abide by the European fiscal rules and that attention continue to be focused as much as it has been on the reforms that are vital for the sustainability of economic growth.
Do the asset purchases pose any threat to financial stability?
Large-scale purchases of bonds could pose a threat to financial stability in that the risk of price bubbles forming in some markets may be raised. To counter this, the central banks of the euro area observe carefully how the bond purchases affect financial stability. It is not necessary to change the monetary policy of the whole euro area if bubbles start to appear in asset prices in some countries. Local risks should be managed by measures taken in local economic policy such as requirements for banks to hold additional capital or restrictions on lending for real estate, or a budget surplus. Single banking supervision in Europe will also help in identifying risks in individual large banks better than before. It is extremely important that all possible measures are taken in every member state to safeguard financial stability because if instability emerges, it can quickly pass from one country to another.
How do the asset purchase programmes affect the debt levels of the euro area governments?
The bond purchase programme should not permit governments to increase their sovereign debt by issuing new bonds. The financing of every country in the European Union must abide by common rules that do not allow large budget deficits. In the next year and a half the countries of the euro area will continue to issue debt in the same way as before. This means that the majority of countries will issue new debt to service their old debts. As the maturities of the bonds arrive, new bonds are issued to pay back the old ones. In this way there is no significant amount of new money being created by the issuing of government bonds to finance government activities and so no increase in debt is forecast as a consequence of the programme. The European Central Bank forecast for 2015-17 expects that the debt of euro area governments will fall from the 92% of GDP of 2014 to 88% by 2017. For more details see the website of the European Central Bank.
What is the impact of the expanded purchase programme in Estonia?
The main effects of the expanded programme for the Estonian economy are:
- The expanded purchase programme eases financing conditions and helps boost growth in economic activity. Long-term interest rates will remain low in the years to come and the fall in yields on sovereign bonds will encourage investors to seek out more profitable investments. For this reason there should be growth in investment in the economy in Estonia and elsewhere in the euro area. Increased economic activity in Estonia’s trading partners will give a lift to growth in Estonian exports.
- Although the monetary policy of the central banks of the euro area does not target the exchange rate, the new assets purchase programmes and the market expectations they create have led to a depreciation of the euro. The euro exchange rate is more important for Estonia than it is for many other euro area countries as Estonia exports over 75% of total production. A fall in the euro helps to improve the competitiveness of Estonian companies in foreign markets. It is true that the effect of the fall in the euro against other currencies has been reduced for the Estonian economy by the sharp fall in the Russian rouble. Together the stronger euro area economy, favourable financing conditions and more competitive exporters will aid the Estonian economy.
The chance of the Estonian government taking advantage of the interest from euro area central banks in purchasing government bonds should be considered with caution for several reasons:
- The launch of an expanded programme of asset purchases is not in itself an argument in favour of issuing bonds. Any decision by the state to borrow money should be taken because of an essential need to cover spending above and beyond the revenues of the budget and not just because one possible way of borrowing has become cheaper than it was.
- When plans are made for the state budget, it is very important that they abide by the rules of the European Union and also by national laws that require the budget to be structurally in balance.
- Given the cyclical position of the Estonian economy there is no need to issue additional bonds to fund the state budget. Eesti Pank considers that the Estonian economy is currently in a position where the government should be looking to make savings, not to borrow to cover additional costs.
- Estonia needs to preserve its ability to borrow in the future because the population is ageing quite quickly, which means that there will be fewer workers and more people needing care. The subsidies from the European Union will also start to decrease more and more and both of these changes could make borrowing necessary.
Does the expanded programme make it possible to buy bonds issued by Estonian state-owned firms?
From June 2015 to May 2016, Eesti Pank had a special exemption allowing it to buy the bonds of the state-owned transmission system operator Elering. From June 2016 the central banks of the euro area have been able to buy corporate bonds as part of the asset purchase programme. In Estonia this means that central banks are now able to buy the bonds issued by Elering and Eesti Energia. Six euro area central banks that specialise in this class of assets have bought the bonds of the two companies, the central banks being those from Belgium, Germany, Spain, France, Italy and Finland. The Finnish central bank buys bonds issued by Estonian companies that meet the quality requirements, these currently being Elering and Eesti Energia. The Finnish central bank has been buying the bonds of the two companies since June, but the euro area central banks do not publish a breakdown of their bond purchases by company. The income and risks from the purchases of corporate bonds are shared between all the central banks of the euro area using the capital key of the European Central Bank, which gives Eesti Pank a share of 0.274%. The financial risks of the Elering bonds that Eesti Pank bought earlier as an exception are borne by Eesti Pank alone.
It should be remembered that the amount issued in bonds by Estonian state-owned companies is extremely small in the context of the purchase programmes. Elering has sold 225 million euros of bonds in one issue, and the Eesti Energia energy group has issued 758 million euros of bonds in three issues. The euro area central banks can buy a maximum of 33% of each issue from the secondary market.
What impact will the purchase programme have on Eesti Pank?
The amount of bonds bought by Eesti Pank depends on how much is bought altogether in covered bonds, asset-backed securities and, since June, corporate bonds on top of the purchases of public sector bonds. The purchases of these instruments reduce the amounts of public sector bonds bought, as all these purchases are made within the total limit of 80 billion euros a month for the whole Eurosystem. This means it is not possible to forecast the exact monthly purchases of public sector bonds by Eesti Pank. The monthly purchase volumes are published on the Eesti Pank website.
It is not yet possible to define the increased financial risks to Eesti Pank precisely, as the structure of the bonds bought under the programme is being established only as the programme progresses. As the Eesti Pank balance sheet will increase significantly with the programme, there will be an increase in risk too. The Executive and Supervisory Boards will assess the risk buffers and any need to increase them in the usual fashion.
Eesti Pank has capital buffers of about 450 million euros, which is a lot less than the relative average for central banks in the euro area. The Supervisory Board has announced as a long-term goal that the relative level of capital of Eesti Pank should rise to the average level of the central banks of the euro area, as the balance of risks to capital of the Eurosystem (the central banks of the euro area and the European Central Bank) as a whole is considered when joint monetary policy decisions are made.
Bonds bought under the programme are shown as an amortised cost, meaning that changes in their market price do not affect their value on the balance sheet. Any differences between the market value and the book value are recorded as profit or loss when the security is sold.
The market prices of bonds with maturities of over a year issued by several countries with high credit ratings are above the amount they will pay out at maturity. Buying such bonds is possible, and this would mean there would be negative yield for the central banks. At present it has been decided that bonds with negative yield can be bought up to the deposit rate of the European Central Bank, which is currently –0.4%.
Is there a risk that there will not be enough bonds issued to meet the programme, or that their yields will be insufficient?
In the first months of purchases there has been no sign of a shortage in the supply of bonds, but the programme is flexible enough that any such problems could be resolved should they arise.
Should the Estonian government also issue bonds given the circumstances?
The decision of a government to issue bonds should not be based on the purchase programmes of the central bank. Increasing the national debt has very far-reaching consequences, and so any such decision should not look only at short-term considerations. The demographic trends in Estonia mean that any option of leaving today’s costs for future generations to pay should be treated with great caution.
Debts have to be paid back but as a rule this is not possible, and new bonds are issued to pay back old debts with. It is hard to forecast what interest rates will be in several years time, though it is certainly important to remember that interest rates at the maturity date of sovereign bonds will certainly not be as low as they are at present. If the refinancing of the debt happens to come due at a time when the Estonian economy is facing difficulties, the money needed for refinancing the debt could present a heavy burden for Estonian society.
The Estonian laws on state financing and the European Union rules forbid structural deficits in the state budget. Estonia’s national debt is today around 10% of the total output of the national economy. If Estonia wanted to ignore all the rules and the sensible considerations and to issue the full amount of government debt permitted, it would first need to find purchasers for all the new debt, which would be worth around 30% of Estonian GDP. The result would be a quadrupling of Estonian sovereign debt within less than two years to 40% of GDP. No European state has ever tried to quadruple its debt in such a short space of time. Such a large increase in debt in absolute terms and as a percentage would lead to a sharp drop in the country’s sovereign rating and probably to a sharp rise in interest rates for companies and households.
The next problem would be how to use the money. As Estonia is such a small country, such large orders for work by the state from the construction industry for example would risk making prices rise for construction work, raising them for companies and households too. Industries supplying the public sector would earn larger profits for some time, but this would come at the expense of growth in other industries.
It must be remembered that sectors funded by debt would have to earn the money back. The reason that we do not have bridges and tunnels in every place that we could imagine them being is that such things would not earn back the money invested in them. Sovereign debt also has to be paid back and every loss-making decision would increase the burden on the state budget.