ECB Buys the Wrong Kind of Bonds

Mark Gilbert is a Bloomberg View columnist and writes editorials on economics, finance and politics. He was London bureau chief for Bloomberg News and is the author of “Complicit: How Greed and Collusion Made the Credit Crisis Unstoppable.”
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The European Central Bank has kicked off the effort to inflate its balance sheet by as much as 1 trillion euros ($1.3 trillion) by buying 1.7 billion euros of covered bonds. The mismatch between those two numbers illustrates the scale of the challenge; as the euro region's economy worsens, the pressure on the central bank to add government bonds to its shopping list is growing.

Lending to companies and households in the euro region shrank at an annual pace of 1.2 percent in September, figures yesterday showed. That marks an incredible 29 consecutive months of contraction, and it compares with average growth in the past decade of 5.5 percent.

QuickTake Europe's QE Quandary

It's impossible to know whether the slump is due to an absence of demand from borrowers or a paucity of supply from the financial industry; it's most likely a combination of both. But the chart below showing lending growth tells you that animal spirits in the euro zone have been dead for more than two years, with scant evidence of any revival:

There simply aren't enough asset-backed securities and covered bonds in the market for the ECB to soak up in return for goosing the economy to the tune of 1 trillion euros. The ECB surely knows this.

There are, though, plenty of government bonds, if only President Mario Draghi could overcome the Bundesbank's resistance to letting the central bank make such purchases. The data in this week's ECB stress tests of the region's banks might come in handy in the argument.

Those stress tests show a blockage in bank balance sheets that's obstructing the flow of credit to the economy. Europe's financial institutions own an astonishing 1.83 trillion euros of sovereign debt, according to figures compiled by Bloomberg Intelligence analysts Jonathan Tyce and Arjun Bowry. As Tyce and Bowry point out, record-low yields in many markets mean the banks are earning almost no return on those investments:

The vicious circle between banks and sovereign funding costs is a key issue and threat to euro-zone recovery.

The ECB's second weapon in the battle to pump cash into the economy via so-called targeted longer-term loan refinancing operations, or TLTROs, drew bids for just 82.6 billion euros in its September debut, short of the 100 billion to 300 billion euros predicted by economists in a Bloomberg News survey. Now that the stress tests are out of the way, the central bank will be hoping for a more aggressive acceptance in the second round of TLTROs scheduled for December.

A better solution, though, would be for the ECB to finally start buying government bonds. It's hard -- impossible, even -- to see any other way it can get its balance sheet back to the 3 trillion-euro levels of early 2012 without making that move:

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To contact the author on this story:
Mark Gilbert at magilbert@bloomberg.net

To contact the editor on this story:
James Greiff at jgreiff@bloomberg.net