ECB: Assessing Brexit, and Bond Buying Adjustments

Published on July 14, 2016

Key Takeaways:

The European Central Bank will remain firmly in “wait and see” mode at its upcoming monetary policy meeting next week.

The ECB will not contemplate any additional ease until the September forecast revisions, if at all, to allow time to assess any potential fallout from Brexit on what are relatively stable inflation and GDP forecasts for now.

Draghi will repeat a commitment to act if necessary, but we do not believe that will be the case anytime soon.

The ECB is likely at any given meeting, however, to adjust its bond buying parameters to increase the universe of bonds eligible for purchase, we expect at first through an increase in the self-imposed limit on per issue and issuer bond purchases, and perhaps eventually, although not as a first step, by switching over from the ECB key to market size-based purchases that would benefit especially Italy and peripherals.

July 14, 2016

Financial markets reacted with violence to the June 23 Brexit vote, but ECB officials are pleased that despite the surprise outcome, markets appear to have been well braced for the volatility.

In the aftermath there were no serious liquidity constraints to speak of, and the ECB had prepared for the event well in advance through close consultations and supervision of banks with UK exposure. So from a markets perspective it has all worked out well, so far.

The ECB will remain in a wait and see mode for now to assess the impact of Brexit on Eurozone growth and inflation, and if there is any need at all for a policy response down the road.

In the meantime, they are faced with the prospects of a technical challenge in the not too distant future in the increasing number of bonds trading below the ECB’s negative 0.4% deposit rate, and thus no longer eligible for purchase under the Asset Purchase Program.

Adjustments for Bond Purchases

There has been a good deal of speculation already in markets over whether and how the ECB might adjust its existing bond buying program in order to open the universe of bonds that are eligible for purchase.

Some investors are anticipating that the ECB could switch from buying sovereign bonds on a proportional basis based on the ECB Capital Key ratio for each country to one based on market size.

That would allow the ECB to buy a much larger quantity of southern, especially Italian, bonds, where issuance has been high, and less of their more austere northern neighbors, providing a double whammy of regional stimulus and some additional relief to the embattled Italian banking sector at the same time.

While not to be ruled out down the road, that option is unlikely to be the first course of response to alleviating the technical issue of tightness of eligible bonds that can be bought by the ECB.

For starters, ECB officials stress that markets have long speculated on how quickly the ECB and National Central Banks (NCBs) will run out of bonds to buy, but until now the process has gone relatively well, and can go on for some time in the future without hitting serious limitations.

Yes, there are some small countries approaching limits – Estonia for example may have run out of stock now – but the ECB can still buy supra-nationals. So it has not become a crisis, yet.

When approaching those limits, from what we understand the ECB will most likely raise the self-imposed limits on  a per issuer and issuance basis first to find more bonds to buy, rather than change from the capital key to market purchases.

At some point the ECB may very well discuss changing from capital key to other market based measures. But we do not understand that to be under active consideration at the Governing Council level yet, where it would for sure meet with some resistance for “rewarding” deficit spenders.

And beyond moral hazard and the potential creation of perverse incentives, ECB officials point to still complicated questions surrounding credit and central bank balance sheet risk exposures such a switch could create.

Some of those original balance sheet risk concerns were alleviated by the compromise that was struck at the launch of the Asset Purchase Program whereby the ECB agreed to split sovereign bond purchases between the ECB and NCB balance sheets. But they are not all gone.

Under the market capitalization based APP system, Banca d’Italia purchases for example would explode and its potential risk exposure rise along with it. Under the hybrid purchase program Germany’s Bundesbank could find some solace in that the additional risk would reside mostly on the Italian central bank balance sheet, and not on the ECB or BUBA’s. But there remain lingering concerns still over the possibility of eventual mutualization of those credits were those liabilities to explode beyond control.

Having said that, there is the flexibility in the APP structure that would not have been there if all the purchases were held on the ECB balance sheet, and the political climate has changed since the battles of 2012-13.

And indeed, we do not sense this is an option that faces so much opposition that, if needed, it would stay closed forever.

The Near-term Impact of Brexit

Beyond adjustments to the bond buying program, the bigger question facing the ECB Governing Council will be whether and how much of an impact Brexit may have on the Eurozone real economy, and if so when that might start to show through?

All kinds of guesstimates and calculations have been offered on that to date, but ECB officials say it will take “some weeks” to even start to get initial proper internal calculations on the potential impact of the Brexit vote. That means at the earliest, the quarterly staff projections for the next policy meeting in September.

ECB President Mario Draghi himself suggested a 0.3% to 0.5% estimate of a hit to Eurozone GDP from Brexit, cumulatively over three years or so, in remarks to European Union leaders in the immediate aftermath of the Brexit vote. But ECB officials emphasize these were very rough, back of envelope, guesses, indeed drawing in no small part on private sector work, and not really ECB crunched figures per se.

As an aside, those estimates for the Eurozone are also predicated on the assumption that Brexit will knock some 2% to 4% off UK baseline growth over the next three years.

The medium term impact will of course take far longer than a month or two to gauge. For example, there will be no visibility on tariffs and trade for two, maybe two and half years as Article 50 is invoked and negotiations get underway.

But there will be a very real direct impact on the Eurozone in the near term from the enormous deprecation of Sterling against the Euro since the June 23 vote.

The initial sense at the ECB is that in the near term the Sterling move is more likely to be absorbed in a loss of export sector corporate margins, for example with German autos, than in trade volumes.

The Tougher Questions

In looking at the UK, and longer term impact of Brexit on the Eurozone economy, ECB staff is however focused most keenly on potential hits on the investment side, and on housing and real estate.

While there could be some short term hit to larger durable purchases, given the starting point of a relatively healthy economy and strong employment, the ECB expects the British consumer in large part to “keep calm and carry on” with their day-to-day spending and consumption.

But uncertainty and hesitation on the investment and property side could linger for a considerably longer period of time, and prove a real source of medium term drag.

Of course if London real estate was to drop a bit from nose-bleed levels, it may not be the end of the world in and of itself. But long periods of uncertainty in and of itself are a source of risk. Will corporate relocations from London converge on Frankfurt, Luxembourg, or Dublin, where US companies especially already have a substantial presence? Or will they really happen at all?

Outgoing Chancellor George Osborne’s announcement of plans to cut the corporate tax rate to compete better, for example, with Ireland would be helpful to counteract any blow from Brexit to the UK. But with a new regime now in place, implementation will remain to be seen.

And the broader question may not be so much one of taxes, but how much does the City retain its role as Europe’s financial hub center, and the resolution of the financial “passport” issue with the EU

Negotiations will clearly entail the tradeoff between migration, where the UK politicians will have to keep some promises to the electorate, and the passport – a politically fascinating tradeoff in the UK between the interests of the City and the will of the rest of Britain (England).

But for now, it is far too early for the ECB, especially with financial market risks having subsided, to accurately gauge or respond to any economic blowback, if at all, from Brexit.

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