The governing council of the European Central Bank won’t meet this week in Frankfurt but rather in Vienna’s Hofburg Imperial Palace.
Both the meeting site and agenda are unusual. The council’s 25 members — including governors of the euro zone’s national central banks and the ECB executive board — will discuss a course of action expected to roil the markets for weeks: buying corporate bonds.
The controversial program bears the acronym CSPP — for Corporate Sector Purchase Program — and it marks a new level of escalation in the 19-nation euro zone’s monetary policy.
In effect, it means the central bank will assume the role of commercial banks and investors. The ECB will be issuing billions of euros in loans to selected companies in the future – in some cases even lending money directly to companies themselves.
The goal of the new bond-buying phase is to drive up the price of corporate bonds while pushing down the interest rates that companies pay to get a loan. Overall it is intended to stimulate investment, economic activity and economic growth.
It’s also meant to boost consumer prices, which have been virtually stagnant over the past few months in the euro zone and far away from the ECB’s goal of seeing prices rise 2 percent every year.
Whether the program will be successful, however, is questionable. While supporters argue the ECB has little choice but to push forward, for critics the trouble with the euro zone’s economy right now is not a lack of cheap liquidity — it’s more like a lack of confidence in monetary policy.
Now, the ECB runs the risk of ruining that confidence once and for all. By purchasing corporate bonds, the ECB’s critics argue it could distort competitive conditions on lending markets and exacerbate a crisis for private investors — all while building up billions in balance-sheet risks to taxpayers.
“The ECB creating fiscal risks without authority is a direct attack on German democracy.”
Ten years ago, it would have been fantasy to predict that the European Central Bank would buy government and corporate bonds on such a major scale. But in the ongoing battle to overcome the debt and euro crises that has gripped the currency bloc for the bast six years, ECB President Mario Draghi and his crew have abandoned almost all previous taboos in monetary policy.
First, they loaned money from the central bank to commercial banks at the best possible conditions, without end. Then they bought covered bonds and loan securitizations from them. In March of last year began an ambitious program of government bond buying. In that time, the guardians of the euro have so far bought bonds valued at nearly €800 billion, or $890 billion.
Now they plan a shopping spree on the corporate bond market. ECB President Mario Draghi announced the project in March and it will be launched in June. At least until March of next year, €80 billion in additional bonds – from now on a mix of both government and corporate bonds – are to be added monthly.
Details of the program show that we’re dealing with bulk purchasing. Marco Stöckle, head of corporate credit research at Commerzbank, calls it “aggressive.”
For instance, the ECB is targeting euro-denominated bonds with a maturity of between six weeks and 30 years. It plans to apply an issue share limit of 70 percent, or up to 33 percent in public undertakings. The purchases will be carried out by six national central banks, including Germany’s Bundesbank.
The bonds will be purchased on both the secondary market (meaning from banks and other investors) and on the primary market (directly from the issuing companies).
At the same time, the company must have an adequate credit rating and have their business headquarters in the euro zone. Bonds for euro-zone subsidiaries of foreign parent companies are also eligible for the shopping list. The ECB will not buy the bonds of banks.
In total, Mr. Stöckle estimates bonds valued at roughly €800 billion will come into question.
“The monthly purchasing volume is likely to be between €3 billion and €5 billion,” he predicted.
That may seem like a small amount of the ECB’s overall program, but it’s already having an impact on markets, before the ECB even buys its first corporate bonds. In anticipation of falling yields, investors have pounced on corporate bonds in the last couple of weeks, forcing down yields for issuers with a solid credit standing from about 1.75 percent in early March to 1.4 percent now. For comparison, at the beginning of the year the effective yield rate was still over 2 percent.
Some experts believe it is unlikely, however, that companies will be tempted by the lower financing costs to borrow even more money to invest in machines and facilities, as the ECB hopes.
“Weak investment activity is tied to uncertainty in the economy and economic policy,” said Thomas Mayer, Deutsche Bank’s former chief economist and now the director of Flossbach von Storch Research Institute. For that reason, he said, the slump in investment cannot be overcome with low lending rates.
Mr. Mayer is afraid instead that companies will use the low lending rates to buy back their own stocks on credit. That would come at the expense of equity capital ratio and endanger the financial resilience of companies in times of crisis, he said.
So instead of putting the real economy on a more stable basis, the ECB could ultimately accelerate the debt spiral, he argued. “The credit system is becoming more and more fragile,” Mr. Mayer warned.
All investors have been feeling this. In recent years, they could react to the current environment of record low interest rates by buying corporate bonds instead, and still earn relatively respectable returns. But those times are long gone.
“Returns on corporate bonds are so small, compared to transactions costs, that trading in them is hardly worth it any more,” said Mr. Stöckle. As a result, investors are keeping bonds in safekeeping accounts and the market is in danger of drying up.
“Returns on corporate bonds are so small, compared to transactions costs, that trading in them is hardly worth it any more.”
For that reason, Mr. Stöckle said he expects the ECB will be forced to buy half of the targeted volume of bonds directly from companies on the primary market. The risk here is that the central bank will drive institutional investors like insurance companies and pension funds – groups that tend to dominate company issuances – to search for returns in riskier asset classes instead.
It is still to be determined how the central bank’s purchases will be organized according to region and sector. ECB sources say it will be orientated on the structure of the whole market for corporate bonds in the euro zone, and attempt to replicate it.
But that won’t be easy if the secondary market dries up in some regions and not enough can be found on the primary market. Guardians of the euro would then be forced to buy an above average amount of bonds from some countries and sectors to achieve the total volume targeted.
If that happened, critics argue the that instead of pursuing a rules-based monetary policy, the central bank effectively would be following an interventionist industrial policy – picking winners and losers. Moreover, some market observers fear issuers that actually lack credit worthiness would consider going back to the dried-up bond market.
The distortions could also be amplified by the fact that only companies big enough to finance themselves on capital markets will benefit from bond buying. Smaller businesses could be left behind. The ECB’s toughest critics argue that this would even violate the principle of free and undistorted competition anchored in European Union treaties.
This group of critics, mainly in Germany, is once again taking the matter to court. A couple of days ago, a group of professors and owners of small and medium-sized businesses sued in Germany’s Federal Constitutional Court to stop the ECB’s bond buying.
In its monetary policy, the central bank is acting “with the mindset of a sovereign dictator by limitlessly intervening… in the corporate bond market,” said Markus Kerber, a Berlin lawyer and professor of public finance who initiated the suit. Mr. Kerber is a regular thorn in the ECB’s side, having been a part of numerous lawsuits against the ECB in past years for its various bond-buying programs.
Economist Mr. Mayer is even afraid the ECB could trigger a new wave of mergers and thereby damage competition. The corporate bond program, for instance, might allow capital market-eligible companies to procure cheap money from the central bank in order to buy other companies.
The current bid by Bayer to take over Monsanto, could show where it will lead: More fusions, more concentration of power, less competition. But that is grist for opponents of globalization and anti-capitalists of all stripes.
Taxpayers could also lose out, at least in theory. National central banks are jointly liable for profits and losses from buying corporate bonds according to their share of ECB’s capital. The default risk for Germany’s Bundesbank would be 27 percent.
The fact that this is in no way theoretical can be seen in the ECB’s intention of retaining corporate bonds until maturity — meaning in extreme cases that the bonds will be held up to 30 years. And it is highly likely, during this long period of time, that some companies on the ECB’s balance sheet could go bankrupt or otherwise get into trouble.
“Certain default rates are the rule with corporate bonds, not the exception, even if they are very low in the high-end sector,” said Commerzbank’s strategist Mr. Stöckle.
If the ECB buys up to €5 billion in corporate bonds monthly, as Mr. Stöckle expects, the risk of default for German taxpayers grows every month by €1.35 billion, in line with the ECB’s capital key. Such an amount would of course only be lost if every bond the ECB buys goes bust, which is unlikely.
Yet the fact that such risks are being taken on without the German parliament ever agreeing to the program has nevertheless angered many in Germany. Mr. Kerber, who is suing the ECB in Federal Constitutional Court, said that violates budgetary sovereignty of the Bundestag anchored in Germany’s constitution, known here as the Basic Law. He demands that the highest court prohibit the German central bank from participating in the bond purchases.
“The ECB creating fiscal risks without authority is a direct attack on German democracy,” he said.
It’s a line of argument that has been tried before. A similar lawsuit was filed in Germany when the ECB began buying government bonds. That case was rejected by the European Court of Justice — but Germany’s constitutional court has reserved the last word.
Some fear that Germany’s top court may yet block the Bundesbank from participating in the government purchases when it is expected to issue a final ruling later in June. If it restricts government bond-buying, corporate bonds are also likely to be out of bounds.
Although other national central banks could jump in for the Bundesbank and takeover its ECB purchases, a bond-buying ban from Karlsruhe would be a bombshell on financial markets — and the whole program could lose its legitimacy.
Time is running short. Once the Bundesbank begins buying corporate bonds in the next couple of days, the default risks for German taxpayers will already start growing.
This article first appeared in Handelsblatt’s sister publication, the business magazine WirtschaftsWoche. To contact the author: email@example.com