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Bond backed by ECB debt stash may help wind down QE -report's author
October 12, 2016 / 8:01 AM / a year ago

Bond backed by ECB debt stash may help wind down QE -report's author

* EU policymakers examine sovereign bond-backed security

* Author of proposal says central bank could issue bond

* Securitised model should soothe German resistance

By John Geddie

LONDON, Oct 12 (Reuters) - A bond backed by a mountain of euro zone government debt accumulated by the European Central Bank in its latest stimulus programme could provide a way for the ECB to eventually unwind that scheme, the author of a proposal under review by EU policymakers told Reuters.

The idea of a securitised, trans-national bond, which the European Union’s financial watchdog instructed a team to investigate last month, is seen as an alternative to a long-debated common euro zone bond which has been resisted by the bloc’s economic powerhouse Germany.

Markus Brunnermeier, co-author of the paper outlining the idea, said the ECB might eventually use such an instrument to drain from the economy trillions of euros it has created under its quantitative easing scheme.

He said the government debt the ECB has bought could be used as collateral for a new securitised European “safe bond” which would be issued by the central bank or another entity.

The proceeds of the sale could cancel out the money the ECB has printed to purchase bonds and help to tighten monetary conditions as Europe’s economy improves.

“If you were to unwind QE to some extent then this would be one way to do it,” said Brunnermeier, a professor of economics at Princeton University.

The European Systemic Risk Board, chaired by ECB chief Mario Draghi, declined to comment. In September, it appointed Bank of Ireland governor Philip Lane -- a co-author on an earlier version of the “safe bond” proposal -- to lead a task force of policymakers to consult stakeholders.

Two euro zone sources involved with the task force said one of the aims of the group was to establish whether the issuer of the bonds would be a public or a private entity.

DOOM LOOP

Proposals for a euro-wide government bond mushroomed during the 2011 debt crisis as one way to create an alternative liquid and secure haven for investors and to wean banks off domestic government debt, breaking the “doom loop” that ties the fate of a country’s banks to its sovereign and vice versa.

Most of these ideas involved some form of joint guarantee by member states and faced objections from Germany, the bloc’s largest and strongest economy, which feared it might ultimately have to pick up the bill.

But Brunnermeier said interest in his idea had revived due to political pressures on regulators to overhaul the ‘risk-free’ status of sovereign bonds, which means banks do not have to hold capital against them and can also own as many bonds issued by a single state as they wish.

One source said Germany was more open to this form of euro-wide bond as it does not require an explicit guarantee for new debt sales, and yet would provide an additional risk-free asset that could convince regulators to apply risk weightings to individual country bonds that would finally break the doom loop.

However, smaller countries might push back if the project threatens to further exacerbate liquidity problems in their debt markets and inflate yields on single country bonds as a result.

A second source said the fact the proposal was taken up by a taskforce means “it’s being dealt with rather seriously” but also that “a policy decision is quite far”.

TOO CAUTIOUS

Brunnermeier’s paper lists the ECB among potential issuers and says the underlying bonds could be divided up using the weighting the ECB applies to its QE scheme. But it stops short of tying the success of the scheme to the central bank.

“Perhaps we were too cautious on this front to not imply explicitly the ECB doing that,” said Brunnermeier.

“But, in general, there is broad support among the ECB. Initially there was some resistance, but in general now all the board members are on side.”

The hurdles for the ECB to issue such a bond are high.

The central bank has so far only bought bonds from euro zone countries, while the body looking into the proposal, the ESRB, is pan-EU. Nineteen of the EU’s 28 member states share the euro.

Also, the ECB does not plan on buying bonds forever, while the project would require a pool of collateral kept permanently topped up to maintain regular issuance.

The new instrument would comprise a safer senior bond to be sold to insurance and pension schemes and a riskier junior bond targeting hedge funds.

The danger of the ECB issuing these bonds would be that without sufficient demand for the junior tranche, it would be left owning the riskiest debt.

Brunnermeier said one way to address these issues would be for a separate entity to be set up to purchase the ECB’s debt stock and then issue the safe bond.

He said without tapping the ECB’s stock, putting the project into practice would likely take longer and come at a higher cost if investors were reluctant to sell bonds to the new entity. (Additional reporting by Marc Jones in London and Balazs Koranyi and Francesco Canepa in Frankfurt; Editing by Gareth Jones)

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