Euroland: Credit Easing vs Quantitative Easing

• The ECB is about to embark on credit easing. Jean-Claude Trichet emphasised that the ECB will not be embarking on quantitative easing. We look at differences/similarities and the implications of this.
• Credit easing aims at affecting the risk spread across assets, whereas quantitative easing aims at affecting the general level of the longer-term interest rate.
• The ECB move should be enough to positively affect the market for eurodenominated covered bonds while the effect on the overall bond market is likely to be muted.
• In the current situation of financial distress, credit easing appears as the appropriate response. We believe that the ECB will cautiously go down the road of credit easing, but not take a single step along the path of quantitative easing.
• Credit easing is not necessarily sterilised. EUR60bn, however, only amounts to about 4% of the Eurosystem's current balance sheet. The ECB appears to consider sterilisation important for medium- and long-term credibility.
• Trichet also announced that the EIB will get access to central bank liquidity. This move will help to increase investment in vulnerable sectors and regions. It is not targeted at alleviating government budgets and will do little in this respect.

Not embarking on quantitative easing

Trichet announced after the Governing Council meeting that it had decided in principle that the Eurosystem (ECB and the European central banks) will purchase euro-denominated covered bonds issued in the euro area. Trichet emphasised that the ECB does not see this as quantitative easing: “We are not at all embarking on quantitative easing”. Instead he said that this according to the ECB vocabulary is part of the “enhanced credit support” and could be called “credit easing”.

So what is the difference between quantitative easing and credit easing? In a speech given by Bini Smaghi, Member of the Executive Board of the ECB, on 28 April 2009, we find the following definitions:

Quantitative easing aims at affecting the level of the longer-term interest rate of financial assets across the board, independently of risk. Such type of policy would operate mainly by affecting the market for risk free assets, typically longer-term government bonds.

Credit easing aims at affecting the risk spread across assets between those whose markets are particularly impaired and those that are more functioning.

The argument given by Trichet for buying covered bonds is that this is one of the segments of private securities that have been most affected by the financial turmoil. The targeting of this impaired market is indeed credit easing and not quantitative easing according to the definitions given above. Trichet noted that EUR60bn looks like an appropriate level for what the ECB is trying to achieve. This should be enough to affect the market for euro-denominated covered bonds, which is worth about EUR1,500bn and had new issues amounting to about EUR270bn in 2007 - an activity that has contracted much since then (we estimate that new issuance of euro-denominated covered bonds could amount to just EUR100bn in 2009). But EUR60bn is by no means a bold move. The credit easing undertaken by both the Federal Reserve and the Bank of England is much more aggressive. So far the ECB announcement has resulted in a narrowing of covered bond spreads by 10-15 basis points in Germany and France and more in periphery countries. It has also had a positive impact on trading activity.

The effect of the ECB's EUR60bn credit easing on the overall Euroland bond market, which is worth more than EUR6,000bn is likely to be muted. If a general reduction in longer term interest rates was what the ECB was trying to achieve it could have embarked on some kind of quantitative easing too.

So why will the ECB not embark on quantitative easing? Well, it seems that it is sceptical that it would work in the current situation of bank distress. Quantitative easing has traditionally focused on buying longer-term government bonds from banks, but if banks do not find themselves in a position to pass on the additional liquidity to the non-financial sector the impact on non-government bond yields and private investments could be very limited. In addition, the ECB wants to avoid being on collision course with the Treaty's prohibition of monetary financing. This could in theory be circumvented by trading in the secondary market, but the ECB could easily end up finding itself in a questionable grey zone, which is something it certainly doesn't want to. Finally the ECB would find it difficult to decide on a key for allocating government bond purchases across countries without affecting cross-country spreads in yields and thus differentiating financial conditions for governments, which again is in conflict with the Treaty.

In the current situation of financial distress credit easing appears as more appropriate than quantitative easing. Credit easing also entails the risk of allocative distortions in terms of company size, sectors and regions, but it is not conflicting with the Treaty, and it can directly target the most distressed markets. We believe that the ECB will cautiously go down the road of credit easing, but that it will not take a single step on the path of quantitative easing

Sterilisation and technicalities

Credit easing is not necessarily sterilised. Both credit and quantitative easing aim at increasing the size of the central bank's balance sheet and therefore expand its monetary liabilities. EUR60bn, however, only amount to about 4% of the Eurosystem's current balance sheet (EUR1,510bn at end-April). It is also a relatively modest amount relative to the EUR600bn that the Eurosystem's balance sheet has already been expanded by since the financial turmoil broke out in July 2007.

In the press conference's Q&A session Trichet said that the Governing Council considers sterilisation and the exit strategy absolutely essential to maintain the maximum amount of credibility in the medium- and long-term. This is not the same as saying that the credit easing will be fully sterilised, but it seems fair to conclude that the ECB has a preference for sterilised credit easing.

The credit easing is not to be implemented immediately. The ECB is due to inform about the technicalities at the next meeting on June 4 and probably would stand ready to embark on credit easing shortly after. We will look for further information on what mechanism it is likely to apply, the key for allocating covered bond purchases, how quickly it will buy and what exit strategy it has.

Covered bonds are more widely used in Germany than in most other member states, and it will be particularly interesting to see how the ECB chooses to deal with this. The German Pfandbrief market amounts to a third of the total Euroland covered bond market while Spain accounts for almost 30% and France almost 15%.

Endogenous credit easing

Just to complicate the vocabulary further the ECB is also talking about endogenous (or indirect) credit easing. This is lending to banks at longer maturities, against collateral that includes assets whose markets are temporarily impaired. The liquidity-providing longer-term refinancing operations with a maturity of 12 months, which Trichet announced at the press meeting, is thus endogenous credit easing. The idea is to affect the yield curve over the horizon at which the policy operations are conducted. This can be done effectively by conducting the operations as fixed rate tender procedures with full allotment - and this is indeed what the ECB now does. The ECB already embarked on endogenous credit easing with a widened collateral framework and full allotment for the three and six month's supplementary refinancing operations from October 2008.

Danske Bank http://www.danskebank.com/danskeresearch

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