With inflation remaining low, expectations for it falling and the economy in the euro area staying weak, the Governing Council of the European Central Bank decided at its meeting in September 2019 to ease monetary policy with a varied package of measures. One of these measures was that monthly asset purchases of 20 billion euros were restarted from November. Like in previous years the asset purchases will cover various asset classes, and the programme will cover the third covered bonds purchase programme (CBPP3), the asset backed securities purchase programme (ABSPP), the public sector purchase programme (PSPP) and the corporate sector purchase programme (CSPP).

Asset purchases have been used as monetary policy measures by the Eurosystem throughout almost the entire period since the global financial crisis. The asset purchase programme became more broadly based in 2015 when purchases of public sector bonds started and several separate earlier programmes were consolidated into one single large programme. The asset purchases of the Eurosystem reached as much as 80 billion euros a month at times. Further asset purchases were stopped in December 2018, at which point the balance sheet of the Eurosystem contained 2.6 trillion euros of bonds bought under the programme and inflation appeared to have hit a sustainable upward trend. By September 2019 the forecasts for economic growth and inflation for the years ahead had fallen though, and the Governing Council of the European Central Bank decided to restart asset purchases. The Governing Council expects the asset purchases to run for as long as necessary to reinforce the accommodative impact of its policy rates, and to end shortly before it starts raising the key ECB interest rates. As before, the Governing Council intends to continue reinvesting in full the principal payments from maturing securities purchased under the asset purchase programme.

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 a stimulus to an economy if the traditional monetary policy measures of a central bank are not working as planned and it is lending to commercial banks at interest rates close to zero, or even at negative rates for long-term refinancing operations. Asset purchases let euro area central banks lower the yield on bonds and this leads 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 help keep inflation in line with the target of the Governing Council of the European Central Bank.

What type of bonds are purchased?

The assets purchased under the programme are covered bonds, asset backed securities, public sector 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.

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 Eurosystem capital key. Since 1 January 2019, Estonia’s capital key is 0.2827%.

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. The Estonian government, for example, has not issued any bonds with maturities of 1-30 years at all. In these cases the national central banks make alternative purchases, usually by buying bonds from European institutions like the ESM, the EFSF or the EIB.

What limits are there on purchases of public sector bonds?

Bonds are purchased which have a remaining maturity at the moment of purchase of between one year and thirty years.

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 1-30 year bonds of those states where less than one third of all the bonds are held by central banks of the euro area. The limit on the purchases of the bonds of European institutions is a little higher at 50% of each issue and each issuer. Both limits apply to the nominal value of the bonds, meaning that the central bank cannot buy more bonds even if their market price falls.

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 that have requested a programme of assistance from the European Union. The bonds of those countries can only be bought if they comply with the terms of the programmes, and they may not be purchased while the assistance programmes are under review.

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. Up to 70% of an issue of bonds by private sector companies can be purchased.

Bonds are purchased which have a remaining maturity at the moment of purchase of between six months and thirty years.

Corporate 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 divided?

The risks from the purchases of covered bonds, asset backed securities, European institution bonds and corporate bonds are divided by the capital key of the European Central Bank, so Estonia has 0.2827%. 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.

It has been agreed exceptionally that each national central bank is responsible for the risks of the sovereign bonds bought with its own balance sheet.

Can the assets purchased be sold on before their maturity dates?

The Governing Council has not yet decided on whether or not the assets will be sold after the end of net asset purchases. It intends to continue reinvesting, in full, the principal payments from maturing securities purchased under the APP for an extended period of time past the date when it starts raising the key ECB interest rates, and in any case for as long as necessary to maintain favourable liquidity conditions and an ample degree of monetary accommodation.

How will the large-scale purchase of government debt affect fiscal discipline?

Purchases of assets are no substitute for structural reform as they can only be used to boost economic activity over the short term. The purchases of sovereign bonds make it a little cheaper for governments to borrow and so it is easier for euro area governments to finance their spending 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 because the risk of price bubbles forming in some markets would 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 requiring banks to hold additional capital or restricting lending to the real estate sector. 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. Normal practice for issuing bonds is that the majority of countries 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 not really any new money being created by the issuing of government bonds to finance government activities and so the programme is not expected to cause any increase in debt levels. For more details see the website of the European Central Bank.

What is the impact of the expanded purchase programme in Estonia?

The main ways the programme affects the Estonian economy are

  • The asset purchase programme has eased financing conditions and helped boost growth in economic activity. Long-term interest rates will remain low in the years to come and the lower yields on sovereign bonds 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 has boosted growth in Estonian exports.

The idea that the Estonian government could take advantage of the interest from euro area central banks in purchasing government bonds should be considered with caution for several reasons:

  • The asset purchase programme in itself is not a reason to issue 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.
  • When planning its state finances, Estonia needs to consider 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 that Estonia has been receiving 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 for the public sector portfolio. From June 2016 the central banks of the euro area have been able to buy corporate bonds as part of the asset purchase programme. The Estonian companies whose bonds they could buy were Elering AS and Eesti Energia AS. 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 bought the bonds of the two companies from June 2016, 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 Eurosystem, which gives Eesti Pank a share of 0.2827%. 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. 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 monthly purchase volumes are always published on the Eesti Pank website.

If the Eesti Pank balance sheet increases significantly with the programme, there is an increase in risk too. The executive and supervisory boards of Eesti Pank assess the risk buffers and any need to increase them in the usual fashion.

Eesti Pank had capital buffers of about 436 million euros at the end of 2017, which was 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. The earlier principle was that if the negative yield falls below the European Central Bank’s deposit rate, which was -0.5% in September 2019, only public sector bonds could be bought if needed. The Governing Council decided in September 2019 to extend that principle to the private sector bonds as well.

Should the Estonian government also issue bonds given the circumstances?

The purchase programme of the central bank is not a reason for the government to issue bonds. 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 this is not usually 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 to do this 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 currently around 9% of the total output of the national economy. If Estonia had tried at the start of the asset purchase programme to ignore all the rules and the sensible considerations and to issue the full amount of sovereign debt permitted, it would first have needed to find purchasers for all the new debt, which would have been worth around 30% of Estonian GDP. The result would have been that Estonian sovereign debt reached 40% of GDP within less than two years. 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 have led to a sharp drop in the country’s sovereign rating and probably to a sharp rise in interest rates, which would have hurt businesses and households.

The next problem would have been how to use the money. As Estonia is such a small country, such large orders from the state for work by the construction industry for example would have raised prices for construction work, raising them for companies and households too. Sectors serving orders from the public sector would earn larger profits for some time, but costs would have risen for other sectors.

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 dream of 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.