The ECB's Claims of Unity Are Woefully Misleading

Earlier this month, the European Central Bank announced that it would buy more bonds to stop borrowing costs rising. It was worried that the euro zone economy was in such poor shape that it couldn’t afford to have European bond yields dragged higher by their U.S. cousins.

On March 22, to mark the one-year anniversary of its Pandemic Emergency Purchase Programme (PEPP) — which has expanded to 1.85 trillion euros ($2.2 trillion) — a blog attributed to ECB President Christine Lagarde said the central bank would “significantly” increase bond purchases to stop unwarranted tightening in financial conditions. Lagarde said there was total consensus on the governing council for this move.

As with many ECB claims, this is both trivially true and woefully misleading. There is, in fact, growing pressure within the ECB for it to scale back its bond purchases. European bond yields are likely to rise, therefore, and sooner and faster than the ECB would like.

Lagarde’s comments were trivially true because it is indeed the case that the ECB’s governing council thought it ought to do something or, perhaps more accurately, needed to be seen to be doing something. Even the more hawkish members, the bloc’s northern creditor countries, agreed with this. Whether this is because of rising yields or because of Europe’s cack-handed political management of the pandemic is a moot point. But this is where agreement stopped.

There is no accord among the ECB’s council members as to how many more bonds the ECB will buy, nor for how long it will keep buying. Creditor countries are increasingly fed up of bailing out their more profligate neighbors via insanely low interest rates — the euro zone’s deposit rate is minus 0.5%, two-year German bond yields minus 0.7% and German 10-year yields minus 0.28% — and a European payments system that rejoices in the name of Target2.

Germany is the poster child for the damage caused by negative rates. It has a rapidly ageing population which, to be blunt, can’t afford to retire. That is why, as Andrew Hunt, an independent economist, points out, lower interest rates lead to higher savings. All things equal, more savings means less spending and investment and lower growth. Absent a pickup in growth led by external demand there is thus a positive correlation between the country’s growth and the level of real rates: As rates go down, so does growth and vice versa.

The damage inflicted on Germany’s savings has been savage. The proportion of negative-yielding assets on German banks’ balance sheets has been rising remorselessly. Hunt estimates that, at worst, more than a third of their assets yield less than nothing. Households have been forced to take more risk to generate returns. Alas, their endeavors have been less than successful. Hunt calculates that since 2005 overseas investments have lost the country’s investors more than 1 trillion euros. 

Although German savers and financial institutions are desperate for higher returns, the ECB has been more concerned with gluing the euro area together, by keeping debtor countries’ borrowing costs as low as possible. This is where Target2, which is used by central banks and commercial banks in the EU to process cross-border euro payments, comes in.

Target2 is described by the ECB as merely a settlement system. This isn’t true. In normal settlement, both positions are cleared; there’s no residual exposure on either side. That’s not true of Target2, which is why exposures to it keep rising. In contrast, Fedwire, the U.S. bank settlement system, settles every day.

In fact, Target2 is in effect a way of forcing creditor countries in the euro zone to lend at non-economic rates to debtor countries via their central banks. That’s a wealth transfer. Some idea of the magnitude of that transfer can be gleaned from the net balances reported in Target2. At last count, debtor countries owe creditors some 1.3 trillion euros, a sum that has grown swiftly during the pandemic as the ECB has bought more bonds. Actually, the exposures are probably a lot higher because those numbers do not tell you, for example, who owes what to whom and the ECB won’t divulge those numbers. Tellingly, gross exposures in Target2 have grown by half a trillion euros in the past 12 months.

There are also more explicit examples of the wealth transfer from creditors to debtors. The ECB is meant to buy bonds in proportion to countries’ paid-in capital at the ECB, which would reduce fiscal transfers: In effect, bonds are bought only in proportion to a country’s GDP. You won’t be surprised that those constraints have slipped lately. The ECB says that such proportions will hold over time. Should you be interested, I have some unicorns for sale. Little wonder that creditor countries are mightily cheesed off.

Which brings us back to the latest ECB bond-buying announcement. As I suggested above, northern Europe needs higher rates not lower ones. The region’s politicians are becoming more aware of this and more openly vocal. Despite its lamentable performance at rolling out Covid vaccines, the region will recover. As it does, and inflation picks up, the pressure from creditor countries for the ECB to drastically scale back its bond buying will increase sharply. So will yields.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Richard Cookson was head of research and fund manager at Rubicon Fund Management. He was previously chief investment officer at Citi Private Bank and head of asset-allocation research at HSBC.

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