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Lately, there’s (finally) some talk about a Large Scale Asset Purchase (LSAP) program from the ECB. I ‘d like to elaborate a bit on the implementation of such a program since the Eurosystem structure and the segmented government debt market pose certain issues.

Usually, LSAPs are used mainly to steer long-term interest rates and provide monetary stimulus to the economy by making financing of durable goods purchases and long-term investment (like housing) more affordable. In the Euro case though, the main problem is the disfunctioning monetary transmission mechanism with certain government securities not being perfect substitutes with bank reserves. This is evident if one compares yields with corresponding Overnight Index Swaps:

Euro government securities - OIS

Since there’s still excess liquidity in the Euro banking system, EONIA mostly arbitrages with the ECB deposit rate rather than the MRO rate (since banks with excess liquidity are not the ones borrowing excess funds). As a result, short-term government paper should be mostly considered as the equivelant of a fixed-term deposit at the ECB, making them close substitutes with bank reserves.

It is clear from the above table that core countries securities actually carry a premium (compared to unsecured interbank lending swaps) up to 1 year and arbitrage quite closely for longer maturities. On the other hand, Italian and Spanish paper carry considerable risk and are ideal targets for LSAP. Any GDP-weighted LSAP would waste a large part of resources without having any real ecnomic impact (since they would be a perfect asset swap, replacing assets with roughly the same ‘economic value’).

An important issue with LSAPs is which NCB will actually perform the purchases. As long as non-issuer country NCBs buy securities, any coupon payments will register as an increase in Target2 liabilities (for the issuer country) and contribute to the Eurosystem profits (minus the fixed-term deposit rate used to sterilize any purchases). Unless monetary profits are remmited back to the issuer Treasury, they will be removing domestic interest income and not contribute to any reduction in the current account income deficit of the issuer.

Taking an accounting view, LSAP will remove an interest bearing asset from bank balance sheets and replace it with bank reserves which currently pay close to zero (zero for the deposit facility and close to zero for the fixed-term deposits). The most probable impact will be a reduction in net lending from the ECB by the banks selling the assets, although the speed will depend on if their loans are short-term (MROs) or long-term (LTROs). The net income impact would probably still be negative while it would allow for collateral to be removed from ECB borrowing and made available in private money markets. Any capital gains would provide immediate income for sellers and lower collateral needs of banks borrowing from the ECB and using government paper as collateral (due to positive effects from daily mark-to-market). As a result, a LSAP announcement would probably be followed by excess liquidity banks trying to front-load the ECB.

Since the ECB uses weekly-term deposits to sterilize the impacts of any asset purchases, the net effect would be a reduction in liquidity available for private money markets and a probable push of interbank rates closer to the MRO rate. This means that any LSAP would be accompanied by a reduction of the MRO rate to lower levels such as 0.5% in order to avoid a defacto monetary tighting stance.

Overall, LSAP can be positive but can have several unintended consequences.

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Kostas Kalevras

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