ECB violates its own rules with bond-buying programme

The ECB has bought much more government bonds than previously agreed. When the central bank started buying government bonds in 2015, it promised to buy up to 33% of a country's total public debt. But now, behind the scenes, the central bank appears to be a much higher limit of 50%. In a new presentation by the Central Bank's Governing Council, this higher percentage is mentioned for the first time. Since the launch of the new bond-buying program last year, the central bank has been buying a lot of bonds.

The ECB's first bond-buying programme was still subject to strict rules. In addition to the 33% limit, the central bank also used a fixed distribution key for buying government bonds. In doing so, the central bank tried to stick to its principle of market neutrality. It would not buy more government bonds from Italy than from Germany. These good intentions turned out to be no match for reality. These two principles were already thrown overboard during the new purchase programme of the corona crisis. As a result, the central bank is now buying proportionally more government bonds from the southern countries. It also has much more than 33% of the public debt on its balance sheet in some countries, including Germany, the Netherlands and Finland.

ECB goes beyond its remit

The ECB seems to have lost control of its bond-buying programme. Not only can it no longer guarantee market neutrality, it also does not adhere to the previously set limit of 33%. And this while the central bank itself warns of the negative effects of exceeding that limit: "The 33% limit is a means of preserving market forces and price formation and limiting the risk of the ECB becoming a dominant creditor of eurozone governments."

The central bank's monetary policy is under a magnifying glass, as there is increasing criticism of the bond-buying program. The economy is growing again and inflation is well above the ECB's target. Therefore, a tightening of monetary policy would be desirable. Nevertheless, the ECB is reluctant to taper the stimulus, because it could cause the yields on government bonds of the southern euro countries to rise. When rumors of tapering came out in early November lap Italian interest rates are rising. The interest rate differential between German and Italian 10-year bonds widened to 1.37 percentage points. That was the highest level since October last year.

Estimation of percentage of government debt on the ECB's balance sheet (Source: Frederick Ducrozet)

Interest rate differentials

With its asset purchase programme, the ECB is trying to keep interest rate differentials between government bonds of different euro countries under control. That will be more difficult if she starts to phase out her buy-back program. Italy in particular benefited from the bond-buying programme that was launched during the corona crisis. The interest rate differential with Germany's safest government bond fell from its peak of 2.8 in the spring of 2020 to less than 1 percentage point last month. During the European debt crisis, the interest rate differential was as high as 5 percentage points. The question is therefore how the central bank will continue this balancing act. It is problematic if it has more than half of a country's public debt on its balance sheet, but it is also problematic if the tapering of the bond-buying programme leads to larger interest rate differentials in the currency union. The ECB is likely to choose the path of least resistance.

This contribution was made from Geotrendlines