European Central Bank

Draghi's QE call rings hollow

Mario Draghi's recent call to buy government bonds with newly created money may never materialise - not because it is illegal but because it is too late and too difficult to undertake

PUBLISHED : Thursday, 10 April, 2014, 1:23pm
UPDATED : Friday, 11 April, 2014, 12:25am

European Central Bank president Mario Draghi has finally confirmed the ECB is ready to engage in full-blown quantitative easing (QE) to fight too-low inflation and revive economic growth.

But wait, isn't the main reason the ECB is about five years late to the QE table because launching such a programme would breach its legally enshrined mandate?

The short answer is no.

Article 123 of the European Union's Lisbon Treaty forbids the Eurosystem, which comprises the ECB and the EU's national central banks, from giving credit to or purchasing sovereign debt directly from EU member states.

However there is no ban on purchases of government bonds on the secondary markets, which the ECB has been doing since May 2010, when it began buying the government debt of Greece just after the scale of the country's fiscal woes became apparent.

It did the same for Ireland and Portugal and, when the euro-zone crisis escalated dramatically in August 2011, bought Spanish and Italian paper.

When Draghi assumed the ECB presidency in November 2011, more unconventional policies were launched to ease funding pressure in the euro zone's banking sector.

The hurdles to conducting QE in Europe are more technical and reputational

More than €1 trillion (HK$10.07 trillion) was pumped into the bloc's financial system between December 2011 and February 2012 through the provision of cheap three-year loans to banks. Much of this money found its way into government bond markets, pushing down yields on southern European debt and leading Bill Gross, the founder of fixed-income fund giant Pimco, to comment that the ECB was doing QE by the back door.

It is only Draghi's boldest initiative - the still unused Outright Monetary Transactions (OMT) bond buying scheme - that has stalled.

Launched in September 2012, it has faced hostility from Germany's powerful Bundesbank, which argues that it comes far too close to illegal monetary financing and undermines ECB credibility by dragging the monetary guardian further into fiscal territory. The view was shared by most members of Germany's constitutional court in a preliminary ruling in February, which - while deferring final judgment on the legality of OMT pending a ruling by the European Court of Justice - claimed "there are important reasons to assume [OMT] exceeds the [ECB's] mandate".

A more pragmatic view would be that while the ECB's policy actions have followed the letter of the EU treaty, they have not necessarily followed its spirit.

Indeed, the hurdles to conducting QE in Europe are more technical and reputational than legal. First, Europe's capital markets are not as deep and liquid as those in the US, making purchases of private-sector debt in the form of asset-backed securities for bank loans - a more German-friendly form of QE as opposed to government bond purchases - much more difficult.

Second, the ECB will assume its new duties this year as the euro zone's banking supervisor. It is very unlikely that the ECB would risk launching a politically and operationally difficult asset purchase programme when it is in the process of stress testing banks' balance sheets.

Third, launching QE when market sentiment remains buoyant and southern Europe's economies are finally showing signs of life is a case of slamming the stable door after the horse has bolted.

So where does all this leave the ECB and its preparations to adopt QE?

Draghi told the world last week that the central bank was committed to buying assets - typically government bonds, with newly created money - if needed to fight the economic risks of a prolonged period of too-low inflation.

At just 0.5 per cent in March, inflation is barely a quarter of the ECB's target rate of just below 2 per cent.

But given that the ECB has been all talk and no action when it comes to warding off the threat of deflation in the euro zone, there is ample reason to doubt whether QE will ever be launched.

Do not be surprised if European QE never materialises - not because it's illegal but because it's too late and too difficult to undertake.

Nicholas Spiro is the managing director of Spiro Sovereign Strategy