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How Eurozone QE Works: A Guide to Draghi's News

Interest-Rates / Quantitative Easing Jan 26, 2015 - 03:17 PM GMT

By: Money_Morning

Interest-Rates

Jim Bach writes: European Central Bank President Mario Draghi announced a quantitative easing program today (Thursday) that was complicated, poorly explained, and drastically unlike U.S. QE.

So, to help make sense of this, we drilled down exactly how Eurozone QE works.

First the basics.

Through Eurozone QE, the ECB will pump 60 billion euros ($68.1 billion) a month into the economy. About 10 billion euros of that will come from existing assets and covered bond purchasing programs. But the other 50 billion euros will come from purchases of member countries' sovereign debt, a new development in the Eurozone monetary policy.


The program is expected to last from March 2015 to September 2016. This means Eurozone QE will expand the central bank's balance sheet by about 1.1 trillion euros ($1.29 trillion) over the next year and a half. Draghi suggested that it may, however, be open-ended, as the main aim is to bring inflation back up to around 2%.

Inflation in the last month was negative 0.2%. The Eurozone is in deflation. And deflation kills demand. It reinforces recessions by forcing down wages and pushing up unemployment. It also adds to the real value of debt – the last thing the Eurozone's debt-ridden periphery needs right now.

While QE has been employed in the United States, the U.K., and Japan, it's important to understand that Eurozone QE is very different.

But before diving into that, you'll want to understand why countries are driven to QE in the first place…

The Rationale Behind Quantitative Easing

The situation that many economies have been in since the financial crisis has been referred to by economist Richard Koo as a "balance sheet recession."

In a balance sheet recession, consumers and businesses are deleveraging. Deleveraging leads to deflation. When facing a financial crisis and shouldering heavy debt loads, the private sector will begin to pay off that debt and save more. This will cause consumption to fall, and prices will fall as a result.

Deleveraging also cuts into the number of private sector borrowers. Consumers and businesses aren't going to take out loans when they are trying to pay down debt. That leaves money markets and financial institutions awash with funds from the new deluge of savers and the sudden lack of borrowers. This reinforces deflation.

The only borrower left in that situation is the public sector. Institutional investors will take those savings and park them in super-safe, low-interest U.S. Treasuries. The government will then use that money to fuel government spending and push up GDP.

That's where QE comes in. The U.S. Federal Reserve will buy up U.S. government bonds as well. This will put more money into the banking system and push rates even lower, so as to give the federal government more "fiscal space" to borrow and spend at lower rates.

The borrowing and spending lost in the private sector will thus be made up for in the public sector. The hope is that this public sector activity will put more money into the economy that's being lost to falling demand in the private sector.

QE is essentially a mechanism that gives the government more room to spend with less strain on budgets.

But it doesn't work the same way in the Eurozone.

Why the Eurozone QE and U.S. QE Are Different

When a U.S. bank can't find borrowers in the private sector, it can easily turn to the government. That's because the U.S. is the safest borrower, and the U.S. bank will receive interest payments in the form of U.S. dollars.

Demand for dollar-denominated U.S. loans is not going to be as high in foreign countries as they are in the United States, where the U.S. government is the sole issuer of the dollar.

But the Eurozone is different. Each country has separate bonds that are all denominated in the same currency.

So when a troubled country like Greece finds its banking sector packed to the brim with savings, there's no reason to park those savings in Greece. Greek debt is risky.

Those Greek savings are going to go toward buying bonds of much safer euro-denominated debt in places like Germany.

That's why deflation is especially harsh in Greece in comparison to the rest of the Eurozone. Savings are leaving the country, and Greece is losing more potential buyers of its debt.

That brings us to how Eurozone QE works…

How Eurozone QE Works

Eurozone QE is structured so the European Central Bank will buy sovereign bonds in proportion to what's known as the "capital key." The capital key is essentially the amount each country pays into the European Central Bank for membership, and it's relative to the size of each country's economy to the whole of the Eurozone.

For example, Germany's capital key is around 18%. That means 18% of bond purchases will be of German debt.

The ECB will buy debt with newly printed euros (in reality, they won't print euros, it will simply be a digital transfer from one account to another). Those euros will go to each nation's central bank. And from there, each nation's central bank will be in charge of distributing that money among its financial institutions.

This achieves a few goals. It will push down yields on government bonds. It will also put more euros in the banking system of weaker countries, who saw euros flee as they looked for safer borrowers to invest private savings. Those new euros could then be used to buy a country's government bonds, which will be less risky after QE helps to push down yields.

Additionally, it will provide euros to the member governments essentially interest-free. When the ECB collects interest on each member country's bond, it will return that interest payment back to the member country's central bank. And that member country's central bank will return it to the treasury.

It sounds convoluted, but that's how central banks work. When the U.S. Federal Reserve collected interest on government bonds, it would return it to the Treasury.

Eurozone QE gets a little trickier however when the notion of risk-sharing comes up…

Draghi announced that of the asset purchases, 20% of the risk will be shared. The other 80% will be borne by the individual central banks.

This is to ease criticism from Bundesbank President Jens Weidmann – that's according to Tomas Holinka, an economist from Moody's Analytics in Prague in an email to Money Morning. Weidmann feared that should one country default on its debt, the rest of the Eurozone would be forced to cough up the euros for that loss. Germany, the largest economy in the currency union, would have to foot most of the bill by the capital key standards.

"The ECB won't bear all losses if a country whose government bonds are bought by the ECB goes bankrupt. Only 20% of potential losses will be subject to risk sharing," Holinka wrote.

The Bottom Line: In its own unusual way, the Eurozone found a way to make QE work to its liking. There are still a lot of questions. Everything the Eurozone does is bound to meet opposition and spark discussions over the Eurozone's role as a monetary union. But regardless of how complicated all those factors are, one fact still remains. Eurozone QE is here. The euro will see continued weakness and perhaps fall to dollar parity in the coming months. And the European markets are bound to get a QE-induced boost. You might want to give the Wisdom Tree Europe Hedged Equity ETF (NYSE Arca: HEDJ) a look. It provides the most liquid play for European stocks and hedges against a weakening currency.

 

The dollar strengthened against almost every currency in 2014…but not the yuan. In fact, China has taken steady, calculated steps for some time now to enter the "currency big leagues." And the global implications of China's currency moves could be dramatic…

Source : http://moneymorning.com/2015/01/22/how-eurozone-qe-works-a-guide-to-draghis-news/

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