Are The Eurozone And ECB Turning Japanese?

By Philip Lawlor, managing director, global markets research, Robin Marshall, director, fixed income research

ECB President Draghi recently stated his concerns about the slowdown in the eurozone economy and noted that the ECB still has plenty of scope to expand its QE asset purchase program (Sintra, Portugal, June 19) if required. But this poses two obvious questions: (1) what lessons can the ECB learn from Japanese, and Bank of Japan, experience and, (2) given the scale of recent QE asset purchases, what scope is there for more ECB QE? Further, would the ECB be obliged to broaden the pool of assets that it purchases?

Similarities between the Japanese and Eurozone experience

There appear to be strong similarities between Japan and the eurozone, both in structural economic development and public policy. Aging demographics and weak banking systems have contributed to weak nominal GDP growth, very low inflation, and declining bond yields in both economies. Charts 1 & 2 below show how both eurozone nominal GDP and 10-year bond yields have converged with Japan. So it is unsurprising that Draghi is concerned about the recent sharp decline in eurozone inflation expectations, and if the ECB were to resume QE asset purchases afresh, it would be in response to a similar threat of protracted deflation to the one faced by the BoJ.

Chart 1. Nominal GDP (2-year moving average) in eurozone and Japan

Source: FTSE Russell / Refinitiv July 2019

Chart 2. German and Japanese 10-year government bond yields

Are The Eurozone And ECB Turning Japanese?

Source: FTSE Russell / Refinitiv July 2019

In addition, both the Bank of Japan and eurozone have gone through a process of denial and delayed policy responses to the financial and banking crises that engulfed the Japanese and eurozone economies in recent decades. The BoJ denied there was a problem of bad loans and asset quality within the Japanese banking system in the aftermath of the property and stock market crashes in the early-1990s, and indeed tightened policy initially. Similarly, the ECB raised interest rates twice in 2011, when former ECB President Trichet stated the ECB was concerned about breaching its 2% inflation target and allowed its first liquidity injection to the eurozone banking system to reverse in 2014, tightening policy in the process. Although the BoJ first introduced government bond purchases as a monetary easing measure as early as 2000, Chart 3 shows these purchases grew only modestly until 2012-13.

Chart 3. ECB and Bank of Japan balance sheet expansion – working with a lag

chart 3

Source: FTSE Russell / Refinitiv July 2019

Chart 3 also shows that both ECB and BoJ balance sheets have grown to about $5T in nominal terms, from just over $1T in 2005. At first glance, the ECB appears to have followed a QE policy path, which is as aggressive as the BoJ’s since 2014, but as a share of GDP, the ECB’s recent QE has been much less expansionary than the BoJ’s. As Chart 4 below shows, the BoJ’s balance sheet has now reached 100% of GDP, whereas the ECB’s is still at only 40% of GDP. The ECB also allowed a significant monetary tightening to occur in 2012-13 when its first €1 trn to the distressed banking system was repaid by the banks. The long period of dither, or less than full commitment to QE asset purchases by both central banks despite the Great Financial Crisis between 2008 and 2014, is also captured in Chart 4.

So, the overall Bank of Japan experience has been to pursue relatively modest QE, for a protracted period, followed by a switch to much more aggressive QE purchase programs since 2012-13.

In fact, if the ECB’s balance sheet is lagged by five years, it looks like the BoJ’s five years ago (as a percentage of GDP), as Chart 4 shows. This does not guarantee the ECB is about to embark upon QE asset purchases on the scale of the Bank of Japan since 2013. However, the BoJ experience suggests a more gradualist approach to QE did little to break the inertia of very low inflation, which had become institutionalized in wage bargaining and nominal contract setting.

Chart 4. ECB and BoJ balance sheets, with ECB balance sheet lagged by five years

Are The Eurozone And ECB Turning Japanese?

Source: FTSE Russell / Refinitiv July 2019

Apart from the substantial upgrade to the scale of QE asset purchases, the BoJ has also broadened out the range of its asset purchases to include equity ETFs.

This was in response to BoJ bond purchases reaching a very high share of the government bond market (more than 42%, see Chart 7 below), and broadening out the transmission mechanism through which monetary policy encourages risk taking in the economy. Charts 5 and 6 show that although BoJ equity ETF holdings are still dwarfed by its bond holdings, these ETF purchases have grown rapidly since 2013, and the BoJ now holds approximately 77%* of all yen equity ETFs.

Chart 5. Bank of Japan asset purchases (US$ bn)

Are The Eurozone And ECB Turning Japanese?

Source: FTSE Russell / Refinitiv July 2019

Chart 6. Bank of Japan asset holdings (USD Bn)

Are The Eurozone And ECB Turning Japanese?

Source: FTSE Russell / Refinitiv July 2019

Thus, if the ECB were to follow the broad outline of the BoJ’s QE programs since 2013, in any future rounds of QE, it would first accelerate the program of government bond purchases, but also extend the pool of assets eligible for purchase.

Scope for further QE by ECB – will they be forced to broadening asset class purchases?

However, the main issue for the ECB is that it has already reached the 33% sovereign issuer limit for its government bond holdings for one eurozone member and is close to the limit for others. Chart 7 shows the ECB already exceeds sovereign issuer limits in its holdings for Dutch government bonds and is close to the limit in Germany and Finland. Accelerating purchases of Italian bonds would also involve downgrading the credit quality of the ECB’s holdings, and would likely breach the limits imposed on sovereign QE purchases by the eurozone’s capital key (which restricts holdings by the share of GDP in eurozone GDP). It might also court the criticism that the ECB was prepared to accommodate fiscal deficit overshoots by member countries in its QE asset purchases. This would leave the ECB with the option of either raising the issuer limit from 33% or broadening out the range of asset purchases in another round of QE, including equity ETFs.

Chart 7. Share of outstanding debt owned by central banks

chart 7

Source: FTSE Russell / Refinitiv July 2019

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