Another proponent for QE in the euro zone

  • 15 July 2014
  • From the section Business
  • comments
Euro notes and one euro coin

In the International Monetary Fund's annual review of the eurozone economy, it concluded that the European Central Bank (ECB) should undertake quantitative easing (QE) if inflation remains too low.

The International Monetary Fund (IMF) also answers the 'how' question that has been under debate. They recommend that the ECB buy government bonds in proportion to the capital key of the central bank.

As the ECB's balance sheet consists of the capital contributions of the member national central banks, the capital key breaks down their shares. It is weighted by country in terms of GDP and population, so Germany is the largest contributor at 17%, followed by France at 14% and Italy at 12%.

So, if the ECB were to inject cash and buy a weighted basket of sovereign debt, then it would buy 17% German bonds, 14% French bonds, 12% Italian bonds.

As 43% of the bonds bought would be from the biggest 3 economies in the eurozone and not largely from the periphery, it would help the ECB avoid the appearance of monetary financing of debt, which is prohibited by their mandate.

It's also helped by the recent drop in borrowing costs or yields on bonds of peripheral eurozone countries. This is partly due to deflation pushing down what creditors charge to lend, since bond yields include a premium for expected inflation.

This is essentially the proposal of Martin Feldstein of Harvard for the ECB to buy bonds in proportion to member countries' economic weighting to get around the problem of whose bonds to buy.

An interesting aside is that the capital key comprises 70% of eurozone banks but the rest are EU central banks that are not in the eurozone, for example, the Bank of England contributes 13% and 1.48 billion euros of the subscribed capital of the ECB which totals 10.8 billion euros.

The IMF also discounts the effectiveness of the ECB buying private assets in exchange for cash creation.

The reason is that the volume of such assets, such as covered bonds which the ECB already owns, is too small to make a tangible difference so the IMF says that it should be done in conjunction with, and not as a replacement for, QE.

Also, although they're positive about the ECB's new targeted cash injection into banks known as the targeted long-term refinancing operation (TLTRO), the IMF adds that a large-scale, non-targeted LTRO could expand the ECB's balance sheet and help push up inflation.

As the TLTRO is similar to the Bank of England's Funding for Lending, it's an interesting comment as to whether measures that incentivise banks to lend are more effective than simply making available long-term cash.

It's a two-sided problem relating to the supply of credit (banks lack access to cheap cash or are not lending because they're rebuilding balance sheets) and the demand for credit (firms can't get loans or are put off by high interest rates which is common in the eurozone periphery).

I wrote before about how the spectre of deflation was not only prompting the ECB to think about what it can do as interest rates are pretty much around 0%, but was also changing the perception around the acceptability of QE.

It seems another brick has been laid in the path toward QE as the IMF has proposed a technical way forward.

But, some would say that the block to the ECB doing QE was never the technical issues, but the political obstacles around its mandate and an aversion to printing cash.

The ECB says it is discussing all unconventional monetary policy options. The OECD had already urged the ECB to consider institutional changes to conduct QE. Now, the IMF has given them more to chew over.

No wonder some are expecting a new era of QE this year. This is while the Fed considers raising interest rates as its QE programme is set to end. No doubt, it's going to be a tricky time for the global economy.