News Analysis: Compromise with Germany allows ECB to press ahead with QE program

The European Central Bank (ECB) finally unveiled its trillion-euro quantitative easing (QE) program on Thursday, following a meeting of its governing council in Frankfurt.

Six years after the U.S. Federal Reserve began its own QE program, which is now coming to an end, weak economic growth and negative inflation figures have sparked concern about deflation across the eurozone, and persuaded the ECB that drastic action is needed.

Speaking from the World Economic Forum in Davos, Christine Lagarde, head of the International Monetary Fund, welcomed the arrival of eurozone QE, but stressed that European governments must still press ahead with economic reform.

"It remains essential that the accommodative monetary stance is supported by comprehensive and timely policy actions in other areas, not least structural reforms to boost potential growth, and ensure broad political support for demand management policies," Lagarde said.

Starting in March the ECB will coordinate a program under which 60 billion euros (about 69 billion U.S. dollars) per month of both private sector and public sector bonds are bought on the secondary markets. It is expected to run until September 2016, which would mean a total of 1.14 trillion euros worth of asset purchases, dominated by sovereign bonds issued by eurozone governments.

In what is basically an exercise in printing money, the aim is that the asset purchases will free up capital which then be recycled by investors into other assets. For example banks selling bonds to the ECB will need to invest the proceeds elsewhere, which could stimulate corporate bond buying and fresh lending to companies.

The QE program has run into strong opposition from Germany, and was only able to be implemented after a compromise on risk sharing.

The overall program will be coordinated by the ECB, with the actual bond buying done by national central banks, but crucially the national central banks will only be exposed to potential losses of bonds held on their own balance sheet, instead of all the ECB members sharing the risk on the entire one-trillion-euro program. Only 20 percent of asset purchases will feature risk sharing, leaving 80 percent where risk is not shared.

This goes against the traditional of pooled risk in the eurozone, and is viewed as a negative development, reflecting a situation where Germany has become tired of helping out weaker eurozone countries, instead arguing that they should implement economic restructuring and become more efficient.

ECB President Mario Draghi was repeatedly asked about risk sharing at a packed press conference in Frankfurt, but stressed that it is not important for the effectiveness of QE, which will help stimulate economic growth and bring the annual inflation rate back towards the annual 2 percent target.

"I was surprised at how the risk sharing issue became almost the most important thing," Draghi said, pointing to public discussion in recent weeks, and dismissed the seemingly endless talk about risk sharing as being "futile".

Only having 20 percent risk sharing on purchased assets had allowed the ECB to mitigate the concerns of some countries, while moving ahead with a very large QE program, he said.

Six members of the ECB Governing Council sit on its executive board, including Sabine Lautenschlaeger of Germany. The others are the governors of the 19 euro area central banks, including Deutsche Bundesbank President Jens Weidmann.

The decision to go ahead now with QE was not unanimous, which points to opposition from Germany. It would have been possible to vote through QE against the wishes of Germany, but analysts say that given the importance of Germany as the eurozone's biggest economy, pressing ahead with QE expressly against the wishes of Berlin was not politically viable.

"It is not an ideal compromise, but given the importance of Germany within the eurozone, it would be very difficult for the ECB to proceed if Berlin was openly opposed to the plan, and this compromise does allow the ECB to proceed with an impressively large QE program," comments Dr Christian Schulz, Senior Economist at Berenberg Bank in London.

"Technically it should make no difference to the effectiveness of QE if sovereign bonds are held on the balance sheet of each national central bank, instead of being carried on the ECB balance sheet," says Schulz. "However there is a credibility issue, and concerns that a move away from risk sharing for QE might be seen to signal a lack of commitment to risk sharing across other areas of eurozone monetary policy."

Germany in particular is concerned that very low interest rates on sovereign bonds will ease some of the pressure on peripheral eurozone countries to undertake painful economic restructuring.

Sovereign bond spreads have tightened in recent months, as the markets have already been pricing in QE ahead of the official announcement. On Tuesday Spain sold 9-billion-euro worth of 10-year bonds. In spite of the very low interest rate of 1.66 percent there were orders placed totaling 23 billion euros. Early in 2014 Spain was paying 4 percent on its 10-year bonds.

Asset purchases under QE will be made according to the proportion of the capital subscription to the ECB of each country, which reflects the size of each economy. Thus Germany Bundesbank will buy 18 percent of the bonds under the program, and France 14 percent, but Ireland only 1.16 percent.

The ECB is already on its third round of buying covered bonds (CBPP3), and in this latest round launched late in October 2014 has so far acquired around 30 billion euros worth. An initiative to buy asset backed securities is on its first round, after being launched in October 2014, but only 2 billion euros have been bought so far.

These program could continue at around 10 billion euros a month, leaving the other 50 billion euros for sovereign bonds as well as supranational and agency issuers.

The ECB will buy the sovereign bonds on the secondary market, but views it as important that it buys alongside private investors and so lets the market set the price. Thus there is a cap where the ECB can only hold up to 25 percent of one bond issue, and can only hold up to 33 percent of all the bonds from one single issuer.

Bonds can be anywhere from two-year to 30-year maturities. An analyst from Societe Generale commented after the announcement that "today's price action may see a rebound in the coming days, but clearly with the new injections it is difficult to see yields of Bunds or other government bonds rising substantially from current levels."

There is some scepticism among economists that QE will actually have a big impact, and achieve its goals.

It is expected to further weaken the value of the euro, which would boost exports and for example encourage more tourism into Europe. The euro fell again versus the U.S. dollar after the details of the QE program were announced, hitting an 11 year low of 1.15.

However Draghi stressed that a weaker euro was not a policy goal of the ECB, which has a mandate to target inflation of 2 percent. In December 2014, eurozone annualized inflation rate had dropped to minus 0.2 percent. Endit