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What are the key features of quantitative easing (QE) and what are its likely effects in the eurozone, following the European Central Bank's (ECB's) announcement of an expanded asset purchase programme?
Expanded EUR 60bn asset purchase programme launched by ECB: an expanded asset purchase programme aimed at fulfilling the ECB's price stability mandate has been an-nounced by the ECB's governing council. The purchase of sovereign bonds will be added to the ECB's ex-isting private sector purchase programmes in order to address the risks of a too prolonged period of low inflation.
QE is the creation of (or printing of) money by central banks to buy sovereign bonds with the aim of spurring growth and inflation--central banks create new bank reserves to buy assets from financial institutions. Central banks acquire the bonds and the banks get money in return for those bonds, which they can then use (in theory) to extend credit to households and businesses.
QE should increase the supply of money, which in turn keeps interest rates low (inter-bank interest rates drop because the banks have more financial options following the injection of money). This then encourages borrowing (ie cheaper credit) and spending (rather than saving) which boosts the economy of, and confidence in, the eurozone. Lowering the cost of borrowing should encourage banks to lend and eurozone businesses and consumers to spend more, therefore contributing to economic growth.
The ECB said the QE was prompted to address the risks of too prolonged a period of low inflation. The eu-rozone has been suffering from deflation, creating a risk that growth and economic recovery would stall as businesses and consumers held off making purchases while waiting to see if prices fell further. It is hoped QE will trigger inflation and buoyancy within the eurozone.
In July 2012, the ECB reassured markets that it was prepared to do whatever it takes to maintain financial stability in the eurozone. At the time, this statement alone was enough to reassure markets, although QE was not actually implemented at that stage by the ECB.
QE has already been implemented in the wake of the 2007/08 credit crunch by:
The effect of QE in the US has been to push up asset prices and give people living there an incentive to invest abroad and take greater risks, so boosting the economy.
The ECB announced that it would launch QE for the eurozone by injecting at least EUR 1.1trn into its ailing economy and would buy EUR 60bn bonds each month from banks from March 2015 until the end of September 2016, or longer. The ECB pledged to continue the QE until there is a sustained adjustment to the path of inflation. The ECB's mandate is to target inflation of close to but below 2%--stable inflation leads to predictability and boosts the economy as there is confidence that money will keep its value.
It is believed that Mario Draghi, the ECB president, secured the ECB governing council's backing for a larger amount of QE in return for accepting that national central banks should shoulder 80% of the risks associated with the programme. Only 20% of the new asset purchases will require national central banks to take on risks outside their own borders.
The news came days after the publication of the Advocate General's opinion in Peter Gauweiler and others v Deutscher Bundestag, C-62/14 that the proposed QE programme was legal.
The news of QE sent European stocks upwards as the amount of QE to be injected was larger than the markets had expected.
The news particularly lifted the struggling eurozone economies: the Italian stock exchange rose by over 3%, the Spanish stock exchange by just under 3% and the Portuguese exchange by around 3.5%. Bond yields fell for the weakest countries such as Italy, Spain and Portugal, meaning their cost of borrowing fell, giving them welcome breathing space. As bond yields in Europe fall, the yields of other 'safe' assets will become more attractive (eg US treasury bonds) meaning yields on US treasury bonds are also expected to fall as demand for them increases.
One of the intended effects of QE is to keep the euro weak-the news sent the euro to an 11-year low against the US dollar. Given that exports account for around 44% of eurozone gross domestic product (GDP), a weak euro should boost many European companies which have large export businesses.
The views on QE are divided in a European Monetary Union (EMU) where there are 19 national govern-ments with varying degrees of creditworthiness- Germany has AAA status, whereas Greece has 'junk status' (B with Fitch or Caa1 with Moody's).
Normal risk-sharing arrangements would have required the 19 national central banks of the eurozone to share any losses in proportion to the size of their economies, meaning the German Bundesbank would nor-mally expect to bear a quarter of any losses incurred by the ECB. Further Germany was concerned that if the usual risk-sharing was applied, it would effectively create jointly issued eurobonds (ie bonds whose risk is mutually shared amongst member states) through the back door.
The German members of the ECB spearheaded a campaign to oppose QE and appear to have persuaded the ECB that the risk associated with buying sovereign bonds (which can lose value or even default) should not be borne by the eurozone as a whole. However, commentators fear that under this QE programme, where the funds for distressed banks must predominantly come from their distressed home states (eg Spain must largely prop up Spanish banks), EMU fragmentation is inevitable.
Germany's concern is that it will also let governments of struggling economies (eg France and Italy) off the hook from pushing through unpopular structural reforms such as increasing taxes (ie moral hazard concerns).
A few days before the ECB announced QE measures, the Swiss National Bank (SNB) unexpectedly an-nounced on 15 January 2015 that the Swiss franc would no longer be pegged to (or artificially capped at) the euro.
In September 2011, Switzerland pegged its currency to the euro to curb the Swiss franc's rapid appreciation following the 2007/08 credit crunch. The cap was intended to keep the Swiss franc under control and ensure that Swiss exporters were not hit by a strong Swiss franc (in 2013, around 70% of Switzerland's GDP was in exports, meaning a strong franc wouldn't have helped Swiss businesses). Switzerland effectively became a temporary member of the EMU while the peg was in place.
The SNB appears to have been buying large quantities of euro-denominated assets (stocks, bonds and bills) as required to keep the Swiss franc linked to the euro. This policy made sense in 2011 when the ECB was working on structural reforms to reinvigorate Europe's economy and maintain the euro's value. However, it appears that domestic (Swiss) criticism of the SNB's large build-up of exchange rate reserves (euro assets) and exposure to eurozone government bonds was increasing, and even forced a referendum on whether the SNB should acquire safer gold reserves instead.
The prospect of large scale QE by the ECB, together with the euro's recent downturn against the dollar appears to have intensified the political pressure to abandon the peg. It seems that SNB didn't have deep enough pockets to keep buying eurozone assets and fight the ECB to keep the Swiss franc artificially low or simply decided that the Swiss franc was no longer as overvalued as it was in 2011 and that the cap could go.
Although the SNB had warned that the euro peg wasn't permanent, the announcement of its removal came as a big shock to the markets. Following removal of the peg, the Swiss franc rose sharply, but shares in many Swiss companies and banks (eg Swatch, UBS, Credit Suisse) suffered a battering following fears that exports would be dampened.
In the UK, the sharp increase in the Swiss franc sent the forex brokers, Alpari (UK) Limited and later LQD Markets (UK) Ltd into special administration following turbulence on the markets.
Although Switzerland was not a full member of the EMU, the removal of the peg highlights the potential dis-ruption which could be caused when a strong member exits. Although there has been much debate on the effects of a weaker country (eg Greece, Portugal Spain or Italy) exiting the EU, this recent event highlights that the exit of a strong country, such as Germany or Finland, could equally create problems.
On 25 January 2015, the Syriza party was elected to form a new Greek Government, having campaigned on an anti-austerity ticket. Commentators are concerned that the new Greek Government will backtrack on reforms (eg higher sales taxes and lower state pensions) and seek some form of debt relief. Worst case, if Greece defaults or is unable to agree satisfactory relief by 28 February 2015 when Greece's eurozone bail-out programme (also known as the EU-IMF Troika--three way--bail out) expires, it may exit the monetary union (described in the media as 'Grexit'), causing further shocks throughout the eurozone. David Cameron recently chaired a meeting of senior officials to discuss the impact on the UK of a possible Grexit (the eurozone is the UK's most important trading partner), which demonstrates that it is a real concern. Any British businesses and banks owed money by Greek businesses could struggle to get their money back on a Grexit. However, the main concern for the UK would be contagion from a Greek exit to other weaker Eurozone economies.
Cyprus is heavily dependent on Greek banks and the markets may well focus on Cyprus as the next weakest member state if Greece exits. Likewise, Portugal has similar issues to Greece, including unsustainable debt, highly leveraged corporates and low growth. Once the precedent is set for a country to leave the euro, there are fears that others could similarly be forced out.
However, the markets have welcomed the ECB's earlier decision to include Greek debt in its QE asset pur-chase programme, provided that the new government honour the EUR 6.7bn ECB bond redemption in June 2015.
It is unclear specifically which countries' sovereign bonds will be purchased by the ECB from March 2015 onwards and how the markets will react. Some sceptics doubt that QE alone is enough to revive the euro-zone, saying further structural reforms and single market integration are also necessary.
In the meantime, the negotiations of Greece's Syriza party regarding its bail-out programme will be closely watched by the markets, but only time will tell whether this round of QE is enough to rejuvenate the eurozone and stem the recent tide of European insolvencies. The chaos caused by the SNB's removal of the euro cap is a stark reminder of the inherent unpredictability of the markets and its potential impact on both eurozone and UK companies.
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First published on LexisPSL Restructuring and Insolvency
Kathy Stones, solicitor in the Lexis®PSL Restructuring & Insolvency team.
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