Eurozone November 15, 2021 / 02:19 pm UTC

ECB and Modified QE Options: Increase Share of Supranational Bond Purchases?

By Andrew Wroblewski

We have already noted that rising COVID cases will act as an additional downside risk for the ECB. But possibly more importantly, any prolongation of the pandemic may make it difficult to end the PEPP at the seemingly planned March 2022 deadline and thus will complicate the decision the Board aims to reach next month regarding how QE programs may be modified. But even if the ECB is restricted in fully detailing its QE ‘recalibration’, there are measures it could and perhaps should take.

Bottom line: Among the options regarding reassessing and modifying its QE program is increasing the purchase share of bonds issued by international or supranational bodies, most notably to take account of the marked increase in EU borrowing now emerging. For the ECB, there is a current ceiling or ‘aspired’ share of 10% of total purchases for supranational bonds, which has been in place for some time for the APP, albeit with an erratic month-to-month pattern (Figure 1). But the cumulative purchase share has reached 10% only more recently for the PEPP (Figure 2).

Market implications: The ECB has hinted that this option will be discussed at a series of special council meetings ahead of the Dec. 16 decision, when the Board plans to set out how and when it will modify its overall QE program. Any plan regarding supranational bond purchases would need majority support from the whole ECB Council. Some perspective, history and possible developments might be useful.

Figure 1: APP EU Supranational Bond Purchases Erratic but Average 10% of Total

Source: ECB; share of supranational purchases as % APP total; arrow denotes cumulative average

The European Commission is empowered by the EU Treaty to borrow on international capital markets, on behalf of the EU. It is a well-established name in debt securities markets with a strong track record over the past 40 years. 

These bond transactions are denominated exclusively in euros. The EU’s largest program is the NextGenerationEU (NGEU), which is a temporary recovery instrument that can raise up to €750bn in 2018 prices (or up to 5% of EU GDP), or some €800bn in current prices, through bond issuance. It is one of the main EU responses to the coronavirus crisis, aiming to support the economic recovery and build a greener, more digital and more resilient future. The borrowing will be concentrated between mid-2021 and 2026 and the aim is for it all to be repaid by 2058. Part of the funds — up to €338bn — will be provided in the form of grants while the rest — up to €386bn — will provide loans to individual member states. 

NGEU Already Underway

NGEU started to borrow in June but was preceded by SURE — the EU program to finance short-term employment schemes across the bloc — with the Commission issuing around €90bn of social bonds(1). In financing NGEU, and thanks to the EU’s high credit rating, the Commission seems able to borrow on advantageous conditions. The Commission will then pass the benefit onto EU member states directly when providing them loans or to the EU budget in the form of low interest rate payments on borrowings to finance recovery spending. The size of NextGenerationEU would translate into borrowing volumes of on average roughly €150bn per year between mid-2021 and 2026, which will make the EU one of the largest issuers in euros: It has already borrowed or has plans to borrow around €90bn in H2 this year.

Given the volumes, frequency and complexity of the borrowing operations ahead, the Commission will follow the best practices used by sovereign issuers and implement a diversified funding strategy. The issuance of EU bonds to finance the NGEU potentially represents a small revolution for the European supranational bond market in particular and the whole sovereign market more generally.

Figure 2: PEPP EU Supranational Bond Purchases Now up to 10% of Total

Source: ECB; share of supranational purchases as % PEPP total

Although the EU had been issuing bonds for decades (as a relatively minor player only borrowing for small back-to-back lending programs), with debt issued for NGEU it will become one of the major borrowers in Europe in the coming years. 

A capability of borrowing up to €150bn per year puts it almost on par with major European sovereign issuers such as Spain, albeit still below that of Germany, France and Italy. Notably, the initial issuances to date (i.e. since June) have demonstrated that there is strong interest from investors globally both for the well-rated conventional assets as well as green bonds, which the EU will issue in large amounts, possibly as much as a third of the total.

Attracting Interest

The European Commission has quickly assembled a qualified debt management team with a new, diversified borrowing strategy, similar to that of other major issuers, representing a significant change in the way the EU interacts with financial markets.

To make its debt securities attractive, the NGEU sales are over the whole yield curve ranging from 3 months to 30 years. But this could be enhanced as any extra support from the ECB would be likely to cut the EU’s funding costs and help to boost the status of the bloc’s bonds as a regional benchmark — a role currently dominated by German Bunds. A tilt toward buying more EU bonds would also help the ECB to support financial markets without breaking rules that bar it from owning more than a third of any individual country’s government debt, a widely considered possibility on German and Dutch debt by 2023.

Risks and Opportunities

Aside from allowing the EU to finance its recovery program very cheaply, this could lay the groundwork for a European safe asset and common benchmark yield curve, help develop EU capital markets, improve the euro-area financial and macro architecture, and bolster the international role of the euro. The negative risks look modest at this juncture. Most notably, there were initial fears that a large volume of EU debt issuances could have a crowding-out effect on demand for euro-area sovereign debts. Instead, the opposite may prove to be the case. Indeed, NGEU bonds seem to have caused a crowding-in effect, notably because of demand from non-EU investors, who consider EU borrowing a positive signal that EU countries see a long-run future collectively. 

More controversially, the temporary nature of NGEU remains a limitation. While market participants appear to consider the 2058 time horizon long enough, there does appear to be some appetite from investors for it to become permanent. EU countries could have good reasons to prolong, reuse or even make EU debt permanent if the benefits manifest and the risks do not.

Otherwise, a number of practical challenges are hindering the development of liquidity relative to the more common sovereign: EU bonds are not eligible initial margin under derivatives contracts and there are no futures contracts on EU bonds.

  1. Those qualify respectively under the Green Bond Principles and Social Bond Principles established by the International Capital Market Association.
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I, Andrew Wroblewski, the lead analyst declare that the views expressed herein are mine and are clear, fair and not misleading at the time of publication. They have not been influenced by any relationship, either a personal relationship of mine or a relationship of the firm, to any entity described or referred to herein nor to any client of Continuum Economics nor has any inducement been received in relation to those views. I further declare that in the preparation and publication of this report I have at all times followed all relevant Continuum Economics compliance protocols including those reasonably seeking to prevent the receipt or misuse of material non-public information.