German bond scarcity a key factor in ECB QE extension debate - sources

FRANKFURT (Reuters) - The growing scarcity of German government bonds makes any major extension of the European Central Bank’s asset buying scheme difficult and this will be a key consideration when policymakers decide whether to extend the buys, three sources told Reuters.

European Central Bank (ECB) headquarters in Frankfurt, Germany, July 29, 2016. REUTERS/Ralph Orlowski

German sovereign debt available for purchase by the ECB will be exhausted, at the latest, by the middle of next year, so a meaningful extension would require a redesign of the programme, a contentious issue since growth and inflation are both slowly moving in the right direction, sources with direct knowledge of the discussion said.

The 2.3 trillion euro bond buying programme, designed to revive inflation, is set to run until the end this year but even if policymakers agree this fall to wind it down, an orderly reduction known as tapering would carry it well into next year.

The problem is that the ECB’s self-imposed rules mean it can only buy up to one-third of each country’s debt and given Germany’s relatively low debt level, it is only months away from reaching this limit.

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“I just don’t see where we could find enough German bonds to keep this programme running beyond mid-2018, at best,” a source, who asked not to be named said. “If you want to extend, you have to reconsider the parameters and that’s a difficult sell when everything is going in the right direction.”

“This will be a major factor in our decision on the future of the programme,” the source added.

While the ECB has argued that the programme has built-in flexibility, the comments suggest that such room for manoeuvre is now clearly limited and will constrain the Governing Council.

The ECB has not put a deadline on extending or winding down the scheme but a decision is likely either on either Sept 7 or Oct 26, giving markets several months to prepare.

The ECB declined to comment.

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According to bank analyst estimates, the ECB could run up against the limits for sourcing bonds in Germany anytime between the end of this year and mid-2018.

Jefferies for instance calculates that the ECB’s asset-purchases scheme has another seven months to run in Germany compared with 16 months in France and 25 in Italy.

The ECB could substitute German debt for bonds of supranational institutions or municipalities, but these markets lack the type of liquidity for the necessary volumes, the sources said.

Already running out of longer-dated German bonds, the ECB is now buying shorter and shorter papers, booking losses as yields are deep in negative territory. Indeed, German bonds bought in May had a maturity of just four years -- the shortest since the scheme was launched in March 2015.


The key contention is whether the slow rise of inflation would justify a major redesign, which could open legal debates and generate fierce opposition from more conservative countries, including Germany, the bloc’s biggest economy and home to the ECB.

Having flirted with deflation two years ago, consumer prices are rising again but will not hit the ECB’s target of just under 2 percent for years to come. Tapering in such an environment could be seen as giving up on the target, some critics argue.

“The reasons why we launched this programme are no longer there,” a Governing Council member said. “We fought off the threat of deflation and the risk of contagion between member states after the debt crisis.”

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Indeed, ECB board member Benoit Coeure recently argued that inflation is less dependent on the ECB’s monetary policy measures, which suggests that inflation is becoming self sustaining, a key criteria for the removal of ECB stimulus.

Another problem is that a major redesign would meet fierce opposition from Germany and its allies, a potentially costly battle.

“Why not hold off on that battle until you have an emergency or urgent situation?” a third source said. “With inflation pointing in the right direction and growth moving higher, this is not a necessary fight.”

The ECB has already looked at lifting its self-imposed limits but concluded that altering many of them, like the 33 percent limit on each country’s debt, could open the door to legal challenges.

“I suspect and fear that the technical constraints have become a policy constraint as well,” said Pictet Wealth Management senior economist Frederik Ducrozet.

“I think it will transpire in their decision. It is clear,” said Ducrozet, who estimates that the ECB already bought less German paper in April and May than the country’s shareholding in the bank would warrant.

Reporting by Balazs Koranyi; Additional reporting by Dhara Ranasinghe in London; Editing by Toby Chopra