ECB risks undermining QE if it opts for compromise plan

The ECB is considering three main options for pumping money into the struggling euro zone economy but two of them could hurt confidence in the bloc’s most indebted states, defeating the object of the exercise.

With euro zone consumer prices falling in December, for financial markets it’s no longer a question of whether the European Central Bank will act to boost economic growth and ward off a deflationary spiral, but when.

President Mario Draghi may announce an ECB program of buying government bonds, using newly printed money intended to flood the wider economy, as soon as the Governing Council’s next policy meeting on Jan. 22.

The main scenario for markets is that the ECB will join its U.S., Japanese and British peers in launching quantitative easing (QE) by buying government bonds in amounts proportionate to each euro zone state’s shareholding in the bank.

Option two is that national central banks buy the debt of their own governments, so the risk remains with the country in question. The third is the ECB buys only triple-A rated bonds, hoping that investors would turn to the lower-rated debt of weaker euro zone government which, while riskier, offers a better return.

However, economists believe the second and third options could backfire. If the ECB were unwilling to take on the risk of holding Greek, Italian, Spanish or Portuguese debt, private investors might ask themselves why they should do it.

The main scenario preferred by investors appears most in keeping with the solidarity principles of European monetary union. If the ECB had to take losses on the bonds of a member state which could not repay its debt, the central bank would have to be recapitalized by all 19 euro zone governments.

Private investors would also suffer losses in any debt write-off but at least the pain would be shared. By contrast, options two and three would not spread risk across the union; investors could therefore seek a premium on lower-rated bonds, pushing up yields for the governments of the very countries that need lower borrowing costs most.

 Varchev Traders

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