The market’s reaction to European Central Bank (ECB) president Mario Draghi’s asset-backed securities (ABS) and covered bond (CB) purchase programme announcement last week left little doubt it was seen as something short of full-blown quantitative easing (QE), with audible murmurs of disappointment.
Some argue the plan is QE by another name and will prove equally capable of weakening the euro and jolting the eurozone into growth as full-blown QE.
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| If one included ABS mezzanine tranches, the total ABS programme could potentially be large enough to achieve Draghi’s balance-sheet goal Nick Beecroft |
“It is perhaps strange that the market sees the ABS purchase programme as less impressive than a full-scale QE scheme, a la the Federal Reserve, Bank of England and Bank of Japan,” concedes Nick Beecroft, senior market analyst at Saxo Bank.
This might have more to do with presentation than the underlying substance of the respective measures, he suggests – an irrational perception that ABS will not create the subjective ‘feel-good factor’ with which QE has come to be associated.
Valentin Marinov, head of European G10 FX strategy at Citi, sees it differently. The ECB’s new measures, which combine the ABS and CB purchase programme with negative rates, is “a game-changer that will boost bank exposure to the real economy via loans”.
In this, the ECB is a trailblazer. “The ECB is the first major central bank to combine QE with negative deposit rates, so both pumping money into the system and incentivizing spending it,” says Marinov. “It is a turbo-charged QE.”
The ABS programme might offer distinct advantages over a government bond-purchasing programme, suggesting Draghi might not see it as a compromise, but a more targeted improvement.
“QE is more likely to help the bigger corporations, but by clearing banks’ credit channels the ABS programme is more likely to help the SMEs [small and medium-sized enterprises], which should in turn be more beneficial for growth,” says Jose Wynne, head of FX research at Barclays.
More favourable
It is understandable that the market was hoping for a QE programme that looked more like the Fed one, says Citi’s Marinov, but he predicts the market will come to view the ECB’s measures more favourably than it did at first glance.
“It was the same with the LTRO [long-term refinancing operation] announcement in 2011 – the market response was delayed because it took a while to digest the implications,” says Marinov. “There wasn’t a big immediate response to the outright monetary transactions either, or the negative deposit rates announced in June this year.
“But in retrospect it is clear that banks responded positively to those measures. The ECB has delivered a lot.”
The market can be forgiven for some level of confusion regarding the ECB’s strategy. The ECB’s new-found regard for the ABS market comes after years of undermining that same market by offering cheaper funding via three-year LTROs.
Both the QE and ABS/CB purchase schemes share key characteristics. Both are designed to promote bank lending to non-financial institutions and seek to actively increase the size of the ECB’s balance sheet back to its former €3 trillion glory.
| The biggest difference between QE and this ABS programme is that the ABS market is finite whereas the government bond market is basically unlimited Gary Jenkins |
Indeed, the ECB’s programme should be seen principally as a means of achieving this balance-sheet expansion, says Mark Wall, chief economist at Deutsche Bank, adding: “If banks don’t do enough to expand the ECB balance sheet by pulling liquidity out with the TLTRO [targeted LTRO], the ECB will stand ready to push liquidity into the system via ABS/CB to achieve its objective.”
The ECB’s balance sheet of €2.01 trillion is about €1.1 trillion (or 35%) below its peak of €3.1 trillion at the end of June 2012.
“Taking Draghi’s €1 trillion TLTRO take-up reference from July into account and adjusting the balance sheet for the outstanding three-year LTROs would imply a targeted size of the two purchase programmes of around €450 billion,” states Nomura.
This sets the ABS/CB programme and traditional QE in contrast to the more passive LTRO scheme, which relied on banks to apply for capital. Yet, like QE, the ABS purchase programme also depends on demand from non-financial institutions. Neither strategy does much to stimulate demand for credit among businesses.
“The biggest difference between QE and this ABS programme is that the ABS market is finite whereas the government bond market is basically unlimited,” says Gary Jenkins, chief credit strategist at hedge fund LNG Capital.
Nomura adds: “Considering the outstanding stock of ABS and covered bond in the euro- area, there is limited scope for large-scale asset purchases in these markets without distorting markets to the disadvantage of investors.”
According to the Association for Financial Markets in Europe, the European ABS market is around €1.7 trillion, compared with more than €6.5 trillion in the US. The €2.5 trillion European CB market helps bridge that gap, but it still falls well short of the more than €7.8 trillion European sovereign bond market – especially when you consider not all ABS will meet the ‘simple and transparent’ requirement.
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However, this needn’t condemn the strategy to ineffectiveness. “If one included ABS mezzanine tranches which have been guaranteed, then the total ABS programme could potentially be large enough to achieve Draghi’s balance-sheet goal,” reckons Saxo’s Beecroft.
However, buying enough ABS and CB to make a difference will be a challenge. The ECB has announced CB purchases worth €60 billion but has only acquired around €16 billion. The current incarnation might encounter similar problems.
Getting around the liquidity issue might also divert the focus of the programme away from the assets the ECB wants to buy, towards those it can buy, somewhat negating the theoretical advantages this programme has over buying government bonds.
“Ideally, we believe the ECB would like to target the ABS purchase programme solely at SME ABS bonds,” says Gareth Davies, head of international ABS and CB research at JPMorgan. “Given current outstanding balances and issuance trends, however, we believe this would be challenging to execute in any meaningful size.”
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Another problem is regulation, which again highlights an inconsistency of approach at the regulatory level.
“A revival of the ABS market would very much depend on crucial regulatory changes focusing on the penalizing treatment of ABS under Basel III and Solvency II,” states Nomura.
Regulations can be changed, but it is another obstacle to effective implementation at a time when growth is needed urgently.
“We have to believe that Draghi has thought this policy through and has considered how to get around the problem of illiquidity in the ABS sector, though we don’t know how he will do it and it is quite hard to imagine,” says Barclays’ Wynne. “But if it doesn’t work then he will have no other option but to resort to QE.”
Stepping stone
Others remain convinced it will prove to be a stepping-stone en route to Fed-style QE. Draghi’s admission some central-bank governors had called for the ECB to do more supports this view, suggesting at least some central bankers believe the Fed’s approach will be more effective.
“It is astounding that when Draghi was asked the size of the ABS market in Europe, he didn’t know,” says LNG’s Jenkins. “Here is a central banker trying to influence economies, but he didn’t know the size of the ABS market and he didn’t know how much ABS he would be buying.” This, he infers, does not suggest a considered and well-thought-out strategy, but a last-minute job.
Nomura maintains its pre-announcement prediction there is a 30% chance QE will come by the end of this year, rising to a 45% chance in 2015.
“The programme most likely to be implemented would be that which we described as ‘credit and quantitative easing’,” says Nomura. “This would include both public- and private-sector securities, with purchases totalling €500 billion in the first 12 months of such a programme.”