Quantitative Easing and the Eurozone

Presented by – Bianka Kuchcinska

Akshay K. Gupta

Under the guidance ofProfessor Dr. A. Belke, European Economics

Europa Institute, Saarland University

Overview of Contents

• Understanding the QE• Comparative Analysis (Japan, US/UK, the EU)• Impact of QE(till now)• QE in Europe• Main objections towards QE• QE vs Europe’s banks• Conclusions

Understanding the QE• Unconventional monetary policy by the Central

Bank – when the traditional monetary policy has become ineffective

• Increase money supply-interest rates close to 0%• Increase in money supply enables Central bank to

buy financial assets and lower their yield• Simultaneously increases the monetary base• In Eurozone, €1.1 tn. to be pumped in to buy bad

debt @ €60 bn. per month till Sept, 2016 and raise inflation to 2%

• On one hand consumers reduce spending due to various reasons (like loss of jobs etc)

• On the other hand banks don’t lend money due to a risk of default – instead they buy treasuries

• To buy the assets, Central bank creates money electronically, which is transferred to banks

• By buying treasuries, CB increases their prices and lower their yield – this reduces the cost of borrowing for businesses, making them more likely to spend

• Individuals and businesses would get loans they are seeking – stimulating the economic activity

Understanding the QE

Comparative analysis - Japan (2001-2010)• Asset price bubble (1991-2000) – due to

speculation the real estate and stock prices were greatly inflated

• Characterised by rapid acceleration of asset prices, overheated economic activity and an uncontrolled monetary expansion

• The bubble collapsed in 1992, the effects persisted till 2000 leading to economic stagnation (The Lost decade of Japan)

• BoJ resorted to QE – flooding banks with money to encourage lending and borrowing

• BoJ bought Government bonds to lower down the interest rates

• As a result of QE, the monetary base of Japanese economy increased from ¥5 trillion to ¥35 trillion

• In the US, the financial markets had collapsed because of the recession – many corporations were seeking bailouts from the Government

• Characterized by massive debt overhang across the world – Toxic sub prime mortgages

• Fed Reserve started three rounds of QEs phasing 5 years – Purchase of US treasury securities short term and long term), MBS - $800 bn + $600bn + $85bn per month

• BoE purchased assets worth £200 bn (£75 bn later) – Government securities and private sector assets

• Post QE – Economic recovery + Unemployment rate dropped to 6.5% from 12-15% at the peak

Comparative analysis – USA/UK (2009-14)

Comparative analysis – THE EU (2015)• “Sovereign debt crisis” – triggered by US recession as

economic activity plummeted throughout the world• Financialised lifestyle – consumption always high – despite

low or zero wage growth – due to increased access to credit

• Member States (PIIGS) resorted to austerity measures to tone down expenditures – which further plummeted the economic activity in the region– a state of economic stagnation

• ECB initially refused to introduce QE – Germany refused to rebalance economies to soak up more consumer spending and generate growth – “”Schwarze Null”” (Keynesian Fiscal growth)

Impact of QE• Monetary policy can create a basis for high growth. The onus

of realizing the potential lies with the Governments, by the virtue of structural reforms

• In Japan, QE measures turned out to be ineffective largely as the economy continues to stagnate. Even though large volumes of reserves are available and interest rates are quite low, still it is unable to break the status quo

• In US, three rounds of QE have helped in the economic recovery and now the programme is about to be wrapped up

• In UK too, it has helped in economic recovery, but in both the US and the UK, it has led to an “economic inequality”. It’s a matter of research and debate whether this is true or not

• In the EU, it is yet to be seen what exactly is going to be the impact of a huge quantitative easing program

1. Main aim - to stop deflation - to preserve the UnionNOT: monetary financing

2. Predicted size of a programme – 500 to 600 bn €

3. Anything lower than €500 bln would scare the markets: Equity markets would collapse and yields in the periphery would jump as investors would start doubting whether ECB is capable to save the €

4. It would also dissapoint the markets as they are already anticipating ECB’s move to adopt QE, causing the euro to weaken.

Main characteristics of QE

• National central banks remain responsible for 80 % of the bonds issued by their own countries (therefore very limited risk-sharing )

• As opposed to the situation in which 19 central banks of the Eurozone share losses in proportions to their economies.

• This is a result of trade off for having the programme approved.

• Expected resultFragmentation within the euro area

Main characteristics of QE

QE? No, because:

1. Fiscal costs 2. Depreciation of the Euro 3. Less pressure for reforms

Main fear: if a country defaults on its sovereign debt, the ECB is resposoble for it. IE. Among others but mainly German taxpayers.

Counter arguments: Assumptions: - Amount of the programme - €550 billion, - €353 billion will be used to buy bonds issued by countries with a

credit rating of at least A-, - €166 billion will buy investment-grade bonds with a lower rating

(ranging between BBB- and BBB+) - €31 billion will buy sub-investment-grade bonds.

Fiscal costs?

Assuming that in case of default there will be a 50 percent haircut, the maximum loss that the ECB could suffer is €98 billion (50 percent of €196 billion; this assumes that all euro-zone sovereigns rated below A- will default), and German taxpayers will need to absorb one-quarter of this loss.

If we assume a 10 percent probability of default, the expected cost of the operation is €9.8 billion for the ECB and €2.4 billion for the German taxpayer. Still a lot of money, but less than 2 percent of the QE programme.

„Moreover, the present value of the seignorage that the ECB will transfer to the domestic national banks more than compensates any risk associated with a large QE programme. Paris and Wyplosz estimate the NPV of future seigniorage as ranging between €2.3 and €14.5 trillion. Any creative way to use these seignorage revenues as collateral would make QE risk-free (for instance, the ECB would buy €96 billion of Italian bonds and have a collateral of €437 billion). This collateral would be worthless if defaulting countries were to leave the currency union, but one of the objectives of QE is to preserve the union.”

Fiscal costs?

Depreciation of the Euro? Main fear: • Inflationary effects of currency depreciation• Valuation effects on German foreign wealth

Counter argument: the German net foreign position is long in foreign currency i.e.

Therefore, when Euro depreciates - positive valuation effects in the German net foreign assets position.

Foreign currency denominated external assets

+ Domestic currency denominated external liabilities > Domestic currency denominated external assets + Foreign currency denominated external assets

Less pressure for reforms

Main fear: countries rescued by the QE programme will get less incentive to implement reforms which would be the instruments of economic policy

Counter argument: • Many countries in the periphery have a disfunctional political

system – it is doubtful that more pain will improve things. • Moral hazard is heartless…

But Is this argument sustainable? • Game theory • Two handed approach • Tighter integration • Conditional monetary policy – forbidden by ECJ – legal issues

QE vs Europe’s Banks Potential opportunities for banks:1. Looser monetary policy help banks to: - borrow cheaper on one hand i.e. to raise capital – it is cheaper for banks to borrow

since the interest rates are pushed lower- Increase the value of their assets on the other hand – to drive bond yields down the

ECB will have to drive bond prices up – and banks are the biggest sellers 2. QE will help combat deflation and deflation would mean increase of the real value of

the borrower’s debts, leading some of them to default. 3. Higher demand for loans from exporters side (thanks to hoped for depreciation of the

euro).

Potential risks for banks:1. Threat to banks margins 2. No option anymore for „Marurity transformation”

Conclusion: Banks already suffered from soured loans to e.g. Russia or faltering oil firms. QE might be some comfort to them.

Thanks for your attention!