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ECB’s carefully timed QE exit puts focus back on need for euro-area reforms

The European Central Bank’s plan to end its massive bond-buying programme at the end of the year is a return towards more conventional monetary policy, a move whose impact on the euro area sovereign outlook is more nuanced than it first appears.

Scope Ratings’ head of sovereign ratings Giacomo Barisone explains why.

What does Scope make of the ECB’s decision to call time on its bond-buying programme?

The ECB has taken an important decision but let’s not exaggerate its significance either. First, Scope expects that the ECB will continue to reinvest its sovereign debt holdings for the foreseeable future even though net bond purchases are now scheduled to end by year-end. Second, an end to QE should be interpreted as a vote of confidence from the central bank that the euro area economy is now sturdy enough and deflation distant enough a risk that such a broad programme is no longer necessary. This reinforces our constructive credit outlook for European sovereigns in 2018, though Scope has also emphasised the increasing risks to its view in its latest quarterly update. At the same time, the ECB was also influenced by bond purchases running up against self-imposed limitations of not owning more than a third of a sovereign issuer’s bonds or the outstanding amount of a particular issue, which helps explain the timing for exiting QE as much as any expressed view on the economic and inflation outlook.

How reassuring is it in terms of the credit outlook for euro area sovereigns?

The overall impact on euro area sovereign yields should remain modest as long as the Eurosystem continues rolling over the stock of public debt (around 27% of eligible securities) and the central bank normalises interest rates very gradually (with, notably, rates not due for any change until the fall of 2019 at the earliest). That said, the lack of active ECB bond purchasing in the secondary markets in 2019 will have some impact in moments of market turbulence (for example should uncertainty in Italian markets endure) given the important role ECB intervention plays in stabilising financial markets and impeding bad equilibria. While less market support might be credit negative in isolation, the end of QE could also simultaneously reduce the degree of complacency observable on the European and national reform agendas in an era of ultra-low rates. In this respect, the overall impact of a QE exit on the euro area sovereign credit outlook remains to be seen. In addition, important to note is that even after a presumptive end to the Asset Purchase Programme (which as of May 2018 had already bought about EUR 2.4tn in bonds), QE will remain an important option in the ECB’s available crisis-fighting toolkit, which could be reactivated were conditions to change.

How much direct impact on the real economy will the end of the bond purchasing have or will the timing and scale of any future increase in interest rates be more important?

Current growth conditions in the euro area are consistent with an end to the stimulus programme. Euro area growth is at its highest since before the global financial crisis, at 2.4% in 2017 (and 2.2% in Q1 2018 despite a recent slowdown), with unemployment at its lowest level in near 10 years at 8.5% as of April. While achievement of the ECB’s price stability objective is still subject to some uncertainty, it’s also questionable whether QE was ever perfectly positioned to resolve some of the causes of low underlying inflation, given much of the weakness had been due to global factors, the euro area’s slow recovery, low demand for credit, cost-cutting structural adjustments taking place in the euro area periphery, etc. An improvement in annual wage growth to 1.9% in Q1 offers signs that there are factors that could support goods inflation sustainably in the absence of ECB intervention.

However, the impact of ending QE will not be felt equally among all member states. Specifically, those countries most exposed to higher financing rates – for example Italy, with yields much higher than earlier in 2018 – will be left more to their own devices. An exit from QE and, just as importantly, future increases in policy rates could have greater growth and fiscal implications for governments with the largest debt stocks and which require the largest amounts to be refinanced in markets. Overall, this could reveal whether all countries of the euro area are as resilient as assumed as easy monetary policy comes to an end. With few options to ease further should the regional economy reverse, the ECB is likely to take a highly cautious approach to tightening policy.