Free Lunch: Weird, wonderful and worthwhile

9/6/2016

By Martin Sandbu

The European Central Bank pushes the gas pedal a little further

Central bankers on a shopping spree

The latest phase in the eurozone’s monetary easing began yesterday with the European Central Bank’s first purchases of corporate bonds with freshly minted money under a programme announced in March. The FT’s Joel Lewin has all the details, complete with charts, on what, where and how much the ECB is likely to buy. There is also the ECB’s official movie…

Naysayers may take the bond-buying spree as another example of desperate central bankers taking another futile measure. A truer view is that it is a piece of a puzzle that not just contributes to monetary stimulus on its own, but helps the other pieces do their job better.

Looking narrowly at the corporate bond market, there may at first seem to be little to get excited about. Most of the action has already happened. The costs of borrowing for European corporations are at record lows, having already priced in the expected demand from Frankfurt — and it is companies in the eurozone periphery that are enjoying the easiest borrowing terms, as the chart below shows. If anything, there is a risk of disappointment if the ECB buys less than market participants expect.

But the importance of the bond purchase programme should be seen in the context of all the other things the ECB is doing, and of all the things the eurozone economy needs besides lower financing costs for corporates.

First, the programme has clearly revived bond issuance by corporations after a steep slowdown in the winter. That is a good thing: the European business sector is too reliant on bank loans and the more it moves in the direction of market funding, the better.

Second, as businesses take advantage of better terms in capital markets, the banks that would otherwise lend to them are missing out. That should lead banks to ease credit conditions for other customers — households and small businesses — in an effort to make up for shrinking business opportunities elsewhere. Similarly, the buyers of corporate debts, who are getting less back on their investment, will be looking for substitute investments, which will include securities and bank loans. Both of these effects should encourage banks to channel more finance to those borrowers who don’t have direct access to capital markets.

Third, the flipside of any asset-buying programme is that it increases the total amount of money in the banking system, since the central bank uses reserves created out of nothing to pay for its purchases. And since the ECB is charging a negative interest rate on the excess reserves banks hold on deposit with it, more reserves mean more hot potatoes banks’ that reserve managers will try to get rid of by swapping them for other assets in the market. (Or, as Commerzbank is reportedly considering, piling cash in vaults.) More asset purchases, in other words, increases the effectiveness of the central bank’s interest rate policy (though it doesn’t matter which assets the new reserves are used to buy, so there is nothing special about corporate bonds).

The overall point is that any way of getting more money out the door will, through a number of channels, spill over into looser credit conditions throughout the financial system (including outside the euro). So it is no surprise that the latest programmes the ECB has added to its repertoire have coincided with falling yields on government bonds as well. Thus the German government's borrowing cost has reached a new record low, with a virtually zero interest on 10-year bonds. Similar yield drops are occurring all over the globe, driven of course by stimulus not just from Frankfurt but also by other central banks, notably Japan’s. As James Mackintosh writes in the Wall Street Journal, this means that, for all the complaints that savers are being squeezed, anyone investing in government bonds in the past year would have made a killing: the value of 30-year Japanese government bonds has soared by 32 per cent in six months.

Is this “bonkers”, as Mackintosh says? It is weird, to be sure, but there is nothing artificial or irrational about these prices which, again, are down to hot potatoes not bubbles. And it is not just weird, but wonderful, inasmuch as the sluggishness of global economic activity and inflation means even more stimulus is needed to wring the slack out and put human effort and ingenuity fully back to work.

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