Thursday, 22 January 2015

Eurozone QE - making a bad problem worse?

So after much gnashing of teeth the ECB has finally capitulated and is going to start buying government bonds from the market in a desperate attempt to be seen doing something useful.

Of course they have swallowed the line that somehow this is going to increase bank lending across the continent and generate a 'wealth effect'. Of course it isn't because they have their causalities completely the wrong way around.

However the string pushing will no doubt continue until morale improves.

But there is an 'interesting' artefact about to happen due to the way they are planning on structuring their purchases.

The ECB is going to purchase €60bn of government bonds per month "on the basis of the ECB’s capital key". Which is the amount subscribed by the various national banks. In other words on a strict market value basis, the percentage of funds allocated to each country's government bonds will be determined by the capital share ratio.

Similarly the income of the ECB, which will quickly include a very large amount of bond income, is also distributed by the capital key.

The problem is that 10 year German Bunds are at a yield of 0.54% and Greece is 9.22%, with the others in between. And that means that when you add up the income from the bonds Germany will be contributing relatively less to the pot and Greece relatively more. Which when it is split out again as a distribution according to the capital key means that Greece will get back less income than it paid to the ECB in bond income and Germany will get more.

In other words the design of the ECB QE scheme will remove interest income from the private sector paid for by the tax revenue of the member states and then move that tax revenue from the smaller states to the German state - who will then save it.

That means the Germans are likely to have to issue less bonds, whereas the smaller states have to issue more and the dynamic may magnify as the months progress.

Whether the effect is significant I don't know. But it certainly isn't the correct way around.