42 Ecb Qe Bnp March2014

Market Economics | Credit | IR Strategy

Guide to ECB QE 25 February 2014

ECB QE is coming: How will it work? We expect the ECB to announce an asset purchase programme, widely known as quantitative easing (QE), from the summer of this year onwards. In this guide, we set out the reasons why; how it is likely to be implemented; and how we expect markets to perform.

The case for asset purchases Asset purchases are increasingly necessary for the ECB to meet its primary objective of maintaining price stability. Additional conventional measures are not going to deliver sufficient monetary policy accommodation. Therefore, we expect the ECB, reluctantly, to follow other major central banks into balance sheet expansion via asset purchases.

How large a programme? Predicting how the ECB would set the size of an asset purchase programme is more art than science. A range of metrics can be used, including the example of other central banks. Depending on the rationale adopted by the ECB, we expect the initial programme to be in the range of EUR 300-500bn.

Private sector assets or sovereign debt? Complements, not alternatives Central banks are generally reluctant to buy government bonds, and the issues are more complex for the ECB than for others. ECB President Mario Draghi has expressed a preference for buying private sector assets, but there are complications in terms of technical complexity, pricing and the amount of available assets. We conclude that some such purchases are likely (and will be beneficial) but that, like other central banks, the ECB will also have to use the sovereign debt markets to find the depth and liquidity required for purchase programmes of meaningful size and impact.

Implementation: Transparency versus opacity Central banks around the world have used a wide variety of methods in implementing asset purchase programmes. With price stability to be the goal of a future programme, the ECBs QE methodology should be more like those of the Fed and BoE and less like the ECBs Securities Markets Programme.

Market Implications ECB QE would have striking implications, especially in the periphery. And while we dont expect QE to start before H2 2014, experience in the US, UK and Japan shows that markets move well before QE actually starts. So we expect by the end of H1 2014, ie before ECB QE starts:

Spain and Italy yields to fall 60-80bp across the curve and further after QE starts. The French-German spread to fall to 10bp in the 3y sector and to 50bp in the 10y (a

tightening of about 10bp across the curve) with a further narrowing after QE starts.

Core yields to fall marginally until QE starts then to rise once QE is underway. The swap breakeven inflation curve to steepen, with 5y5y swap breakevens rising. We believe that QE is not fully priced into credit spreads and therefore increasing

expectations of QE by the market will have a progressive tightening effect, especially for high beta, as we approach mid-year.

Risks: What if, contrary to our expectations, the ECB begins to downplay the likelihood of eventual QE? If the ECBs reason is upside surprises to inflation & growth, we think our expectations would still likely be fulfilled, albeit at a slower pace. But if retreat from QE were seen by the market as a policy mistake, our expectations for peripheral spreads and inflation breakevens would be wrong.

Authors

Market Economics Ken Wattret David Tinsley Julia Coronado Ryutaro Kono Credit

Olivia Frieser Matthew Leeming Heiko Langer IR Strategy

Laurence Mutkin Patrick Jacq Camille de Courcel Shahid Ladha Tomohisa Fujiki

Market Economics | IR Strategy 25 February 2014 www.GlobalMarkets.bnpparibas.com

1. The case for asset purchases Asset purchases are increasingly necessary in order for the ECB to meet its primary

objective of maintaining price stability. Inflation in the euro area has persistently surprised to the downside, eroding the safety margin against deflation.

Additional conventional policy easing will not deliver sufficient monetary accommodation for the price stability mandate to be met. Thus, the ECB will reluctantly have to follow other central banks into balance sheet expansion via asset purchases.

Diminishing safety margin against deflation Inflation in the euro area is well below the ECBs target of inflation below, but close to, 2% and is likely to remain that way for a long time. The output gap remains large and there is increasing evidence that disinflationary forces are spreading beyond the adjustment in relative prices in the peripheral countries of the euro area. Longer-term inflation expectations have remained anchored but this cannot be relied on to continue given persistently low inflation rates. The threat of a sudden downward shift in inflation expectations is rising and, if this occurs, it would be very difficult to reverse. Indeed, inflation expectations at shorter horizons, including in the ECBs own Survey of Professional Forecasters, have been tumbling (Chart 1).

Monetary policy has been insufficiently expansionary and the safety margin against deflation has been reduced markedly. The risk is increasing that another large adverse shock would tip the euro area into deflation. The ECB has publicly expressed its concerns about this. In our view, there is insufficient scope for conventional monetary policy responses to loosen policy enough to stabilise inflation, let alone to move it back to the ECBs target. More unconventional policy responses are therefore required.

Obliged to take action Predicting the timing and sequencing of future ECB policy changes, including asset purchases, is not straightforward. The cost-benefit analysis of various options is complicated and the diverse range of opinions on the Governing Council is an additional source of uncertainty. Still, for some months, the signals from a range of ECB officials have been clear when it comes to the principle of asset purchases: they are possible, and have become more probable, in the context of persistently low inflation.

Box 1 below contains extracts from comments made by members of the ECB Executive Board going back to last November, following Octobers unexpected drop in inflation. Prominent in those comments, and others made over the period, is the ECBs willingness to engage in asset purchases if it believes it is failing to meet its mandate.

The mandate is laid out in Article 127(i) of the Treaty for the Functioning of the European Union, which states that the primary objective of the European System of Central Banks shall be to maintain price stability see Box 2 below.

Chart 1: Inflation expectations (from ECB SPF) Chart 2: ECB staff inflation projections

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Box 1: ECB Executive Board members comments on asset purchases

Comments by Peter Praet, November 2013 If our mandate is at risk we are going to take all the measures that we think we should take to fulfil that mandate. That's a very clear signal. The balance-sheet capacity of the central bank can also be used. This includes outright purchases that any central bank can do. The rules do not exclude that you intervene in the markets outright. For some decisions it's easier than others [to gain consensus]. One thing is clear: the Governing Council has been able to decide. That's really the message.

Comments by Benoit Coeur, November 2013 Outright asset purchases are one of the tools that the ECB can use to implement its monetary policy so it is, in principle, possible.

Comments by Mario Draghi, February 2013 Question - Would it be possible for you to clear up, once and for all, the issue about monetary financing: is it not the case that if you want to, you can just buy government bonds in the secondary markets and thats not prohibited under the Treaty?

Yes, it is possible. It has been done and it was not against the Treaty. Think of the Securities Markets Programme, that was such a case.

Source: European Central Bank, BNP Paribas

Since the press conference in January this year, ECB President Mario Draghi has stated on a number of occasions that the ECB is ready to use all the [policy] instruments that are allowed by the Treaty. Indeed, he went a stage further in Februarys press conference, responding in the affirmative to a specific question about whether the ECB could buy sovereign debt in the future. In short, he said it had been done before and was not against the Treaty (Box 1).

Legal complications, but QE and OMT are not the same Since these comments were made the situation has become more complex, primarily related to the 7 February announcement from the German Constitutional Court (GCC) regarding outright monetary transactions (OMT). The GCCs referral of the judgement on OMT to the European Court of Justice (ECJ) can be interpreted in various ways. A positive interpretation is that it puts the decision in the hands of the ECJ, which is more likely to conclude that the OMT programme does not breach the ECBs monetary policy mandate. A less positive view is that, if the ECJ does not endorse the conditions proposed by the GCC (which include limiting the scale of asset purchases), OMT will be deemed inconsistent with German constitutional law. This, in turn, would prevent the Bundesbank from participating in OMT and undermine its effectiveness. Our interpretation is that the OMT programme is in a state of limbo. It could be several months before the ECJ makes a ruling and the terms and implications of its judgement are difficult to predict. It is important to stress, however, that even if the OMT programme is not operational, this would not preclude the ECB from asset purchases if it were to consider that failure to do so would jeopardise its adherence to its price stability mandate.

Box 2: Legal aspects of the ECBs mandate

Article 127(1), Treaty on the Functioning of the European Union The primary objective of the European System of Central Banks shall be to maintain price stability.

ECB Definition of Price Stability The TFEU does not provide a precise definition of what is meant by price stability. That responsibility rests with the ECB. Price stability was initially defined by the ECB as a year-on-year increase in the Harmonised Index of Consumer Prices (HICP) for the euro area of below 2%".

In July 2003, the ECB Governing Council clarified that in the pursuit of price stability, it aims to maintain inflation rates below, but close to, 2% over the medium term.

Article 18, Statute of the European System of Central Banks and the ECB In order to achieve the objectives of the ESCB and to carry out its tasks, the ECB and the national central banks may operate in the financial markets by buying and selling outright.

Article 123, Treaty on the Functioning of the European Union Overdraft facilities or any other type of credit facility with the ECB or NCBs in favour of Union institutions, bodies, offices or agencies, central governments, regional, local or other public authorities, other bodies governed by public law, or public undertakings of Member States shall be prohibited, as shall the purchase directly from them by the ECB or NCBs of debt instruments.

Source: European Central Bank

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The latter point was prominent in the comments from ECB Executive Board member Benot Cur in a media interview shortly after the GCC announcement. He made a number of salient points. First, the ECB believes that OMT has been designed in a way that leaves it safely within the remit of the ECB in terms of being monetary policy and not being monetary financing of governments. Second, the status of OMT is unchanged. It was unlikely to be put into practice before the GCCs announcement and this remains the case subsequently. Third, and of most significance from the perspective of the possibility of a future asset purchase programme, a line was drawn between the OMT framework and a sovereign debt market intervention linked to the ECBs mandate to deliver price stability.

To quote Mr Cur: "Mario Draghi has been clear that the ECB can use all instruments that are allowed by the Treaty, and that includes asset purchases. We've done it already, many central banks have done it, including in the past in Europe, and it's being done daily in other regions. So it's possible of course, provided that it is justified in view of the ECB mandate. Within that framework, a range of instruments are possible, and that includes asset purchases.

This supports our interpretation that, while the viability of OMT is uncertain following the GCCs announcement, the latter does not rule out ECB asset purchases if they are made in order to avoid the ECB failing to meet its price stability mandate. If, as appears to be the case, the ECB is keen to distinguish between the OMT framework and a future purchase programme linked to adherence to its mandate, it could do so by choosing a title for the facility specifically related to its purpose: ie, it could use a title such as the Price Stability Facility (PSF).

Note also that a key aspect of the GCCs concerns over OMT is that targeting certain countries for assistance violates the principle that monetary policy should be set for all member states of the euro area. It can be argued that this increases the likelihood that future sovereign debt purchases under QE would be implemented across all member states on a capital-key or GDP-weighted basis an issue discussed later in this note.

Timing the move is tricky but mid-2014 is feasible Predicting how ECB monetary policy will evolve is not straightforward. As already mentioned, the cost-benefit analysis of various policy options is complex and forecasting the timing and sequencing of future policy innovations is made more difficult by the diversity of views across the 24-member Governing Council. Legal matters, related to OMT and German law, are a further complication.

We acknowledge that it is less straightforward for the ECB to engage in asset purchases than it has been for other central banks. With this in mind, the ECB will probably opt to work its way through the less contentious (though also less effective) policy tools first. Still, in recent years policymakers have been forced to implement policies about which they have reservations, as the consequences of failing to act could be far worse.

As QE is politically sensitive and unpopular with some Governing Council members, the ECB would probably avoid doing it if it could. But, in our judgement, the downward trend of inflation and the associated risks will mean that the ECB will have to make its way through a range of conventional and unconventional policy measures this year.

We expect at least one, and possibly both, of the ECBs key policy rates to be reduced at the early March meeting. Additional liquidity measures will probably also be announced, either at the same time or shortly after, with modifications to the ECBs rather vague method of forward guidance also feasible ahead. However, beyond an initial announcement effect, these initiatives are unlikely to have a significant impact on monetary conditions in the euro area. Therefore, if inflation is as low as we forecast it to be by the summer (around % y/y on both a headline and core basis), the ECB will have to broaden its policy response to include balance sheet expansion via asset purchases. We see this summer as a realistic timeframe for this broadening of policy to materialise, with the ECBs quarterly reviews of staff projections in March, June, September and December of particular importance. We interpret the decision to bring forward the 2016 staff projections to March (much earlier than the normal December timetable) as highly significant. As a result of staff forecasts suggesting inflation will be below the ECBs target for another year (2016 would be the fourth year in a row), a majority of Governing Council members are likely to press the case for additional monetary policy accommodation.

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The move towards QE will accelerate if inflation surprises to the downside in coming months and raises the risk of inflation expectations becoming unanchored. March and Aprils inflation data will be particularly important in this regard. In October 2013 and January 2014 pricing behaviour differed from the ECBs expectations and evidence that it was continuing to do so would increase the urgency of a new response.

We see Junes review of the staff projections and the inflation figures to be released before then as probable triggers of ECB asset purchases. This assumes that the ECB will have worked its way through its remaining conventional policy ammunition by that point. We acknowledge the risk that the ECB moves less quickly, with a less weak path for inflation and upward surprises on economic growth potentially prolonging a wait and see approach. But a key aspect of our call is that, in response to a diminished safety margin against deflation, the ECBs reaction function is changing.

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Credit 25 February 2014 www.GlobalMarkets.bnpparibas.com

2. How large a programme? There is no standard way to set the size of an asset purchase programme. Other

central banks have used various methods. Depending on the rationale adopted by the ECB, we expect the initial programme to be in the range of EUR 300-500bn. This would be similar in scale to the initial interventions of other major central banks. However, the US, UK and Japanese programmes eventually became much larger.

Compare and contrast Relative to other major central banks, the ECB has been less willing to embrace the principle of balance sheet expansion and, specifically, expansion via asset purchases. The ECB has implemented three asset purchase programmes since the onset of the financial crisis which are discussed in detail later in this note. Cumulatively, the asset purchases have amounted to slightly less than EUR 300bn, equivalent to roughly 3% of euro-area GDP.

In comparison, the Bank of Englands asset purchases have totalled GBP 375bn, roughly eight times the magnitude of the ECBs purchases when measured in relation to GDP. The ECB has, in mitigation, grown its balance sheet via very long-term refinancing operations rather than through asset purchases. But even with this taken into account, balance sheet expansion has been much smaller in the euro area than in the US, UK and Japan. In addition, early repayment of three-year LTROs has seen a shrinking of the ECBs balance sheet while other major central banks have been aggressively expanding their holdings of assets, with implications for exchange rates.

Chart 1 compares the balance sheets of the Fed, Bank of England and ECB, all rebased on January 2008 levels. The contrast between the rise in the size of the Fed and Bank of Englands balance sheets since 2008, and the increase in the ECBs balance sheet is striking. The Feds balance sheet is almost five times as big as it was in early 2008 and is still rising quickly, despite the Feds decision to taper its asset purchases. (Chart 2 shows the three central banks balance sheets in relation to national GDP. The picture is rather different because the ECBs balance sheet was relatively large prior to the onset of the financial crisis.)

How to do it The ECB is, on the basis of the trajectory of euro-area inflation, failing to deliver the appropriate degree of monetary accommodation. There are various methods to try to assess the potential magnitude of a future asset purchase programme by the ECB. We look at a few of them below, concluding that an initial round of asset purchases of EUR 300-500bn, or around 3-5% of euro-area GDP, is a reasonable assumption.

Broad money shortfall The second pillar of the ECBs monetary policy strategy is an assessment of developments in broad money and credit growth and their implications for inflation over the medium term. Such an assessment currently ought to be clearly indicative of downside risks to price stability. The growth rate in M3, for example, has been running below (generally well below) the ECBs former

Chart 1: Balance sheets (January 2008 = 100) Chart 2: Balance sheets (% GDP)

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reference value of 4.5% y/y growth since mid-2009. Indeed, M3 growth has weakened further in recent months (Chart 3).

In December (the most recent date for which the data are available), M3 rose by just 1.0% y/y. Given the size of M3 (a little under EUR 10trn), it would have needed a one-off increase of around EUR 350bn for it to have grown at the reference rate of 4.5% y/y.

Alternatively, one could look at the cumulative shortfall of M3 growth. In the period from mid-2009 to end-2013, the cumulative increase in M3 should have been in the region of 20%, on the basis of the former reference rate. In reality, M3 rose by around 4%. The implied shortfall equates to around EUR 1.6trn, or some 17% of GDP.

While a helpful reference point, there are some complications with both calculations. With regard to the first approach, the maximum maturity of assets included in M3 is two years, so purchases of government debt of a longer maturity would not raise M3 growth directly.

Another issue regarding the cumulative shortfall in M3 growth is the ECBs belief that broad money growth was excessive prior to the financial crisis. Hence, it is likely to interpret some of the subsequent weakness in M3 growth as a necessary unwinding of the prior excesses. The ECB has never formally quantified this overhang but we can assume that the cumulative shortfall in M3 growth on such a basis would be below (and probably well below) the estimate of EUR 1.6trn above.

SMP scaling approach Total sovereign debt purchases by the ECB under the Securities Markets Programme (SMP) ran to just short of EUR 220bn. The purchases under the programme ran for 21 months in total, from May 2010 to February 2012. (The SMP was formally ended in September 2012 when the framework for OMT was announced.) The run rate of purchases per month was, therefore, around EUR 10bn while the SMP was in operation.

The SMP was only active in peripheral sovereign debt markets, initially in Greece, Ireland and Portugal and subsequently in Italy and Spain also. Those markets combined account for roughly one third of euro-area contributions to the ECBs capital. If we were to scale up the purchases, consistent with buying in all euro-area sovereign markets, this would equate to a run rate of around EUR 30bn per month rather than EUR 10bn. Over a period of a year (the length of both of the ECBs Covered Bond Purchase Programmes) this would equate to purchases of EUR 360bn a similar estimate to the initial, M3-based methodology above.

However, there are some problems with the SMP scaling approach. One is that yield levels in euro-area sovereign debt markets are much lower currently than when the SMP was in use, so the ECB should expect to get rather less bang for its buck in a future purchase programme. Another issue is that the purchases were not evenly spread over the course of the SMP. The bond buying was heavily concentrated in spring 2010 and summer 2011, with roughly a third of the total purchases made in just five weeks during those two periods.

Chart 3: M3 growth Chart 4: Private sector bank lending

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Nominal GDP shortfall Weak output growth in real terms and low inflation are combining to yield low nominal growth rates in the euro area. The ECB could implement asset purchases targeted at compensating for the shortfall in nominal growth, a framework which the Bank of England initially adopted when setting its Asset Purchase Facility (APF) discussed in more detail in Appendix 1 at the end of this note.

One of the complications with this approach is that the ECBs primary mandate is price stability, not nominal growth. Another is that the magnitude of the programme would vary considerably depending on the assumptions made about the appropriate real growth rate and the reference period used. The higher is the assumption of trend real growth and the longer is the reference period, the higher the shortfall in nominal growth would be.

Lets assume a trend real growth rate for the euro area of 1-1% (in our view, the trend rate is lower, below 1%, but the ECBs estimates have historically been rather high at around 2% during the pre-crisis period, for example). If we then define price stability as 1-2%, this would imply a range for euro-area nominal growth of 2-3% (using HICP inflation as a proxy for the GDP deflator).

Since 2009, nominal GDP in the euro area has risen by 6%. Based on the lower estimate of the above range (of 2%), this would imply a cumulative shortfall in nominal growth of about 5%. Based on the upper estimate (of 3%), the implied shortfall would be around 8%. As euro-area nominal GDP amounts to roughly EUR 9.5trn, the estimated shortfalls would translate into sums of around EUR 475bn and EUR 760bn, respectively.

The Bank of Englands initial APF framework, however, was forward looking, linked to estimates of future shortfalls in nominal growth. This would yield much smaller nominal growth shortfalls in the euro area, using the ECBs staff projections as a benchmark. The staff projections as of last December imply nominal growth of 2.2% and 2.8% in 2014 and 2015, respectively (again using HICP inflation rather than a GDP deflator). Based on the lower limit of the range for targeted nominal growth (of 2%), the staff projections point to a marginal shortfall. Using the upper limit of the range (of 3%) implies that nominal growth would fall short by around 2%. In nominal terms, this would equate to around EUR 180bn.

3-year VLTRO expiry The cumulative take-up of the ECBs two very long-term refinancing operations (VLTROs) which took place in late 2011 and early 2012, exceeded EUR 1trn. The net take-up, however, when adjusted for the reduction in borrowing via other refinancing operations, was roughly half the size, at around EUR 500bn. By February 2015, the VLTROs will have been repaid in full (in the absence of another VLTRO being introduced before then, of course). A future ECB asset purchase programme could be targeted at replacing some or all of this expiring long-term liquidity, with banks in some parts of the euro area having used the liquidity to raise their sovereign debt holdings, keeping yields low and easing monetary and financial conditions across the euro area in the process.

The ECB has publicly expressed its unease with the scale of the increase in banks holdings of sovereign debt in some euro-area member states, most explicitly in the press conference in December last year. It could, therefore, step in and loosen monetary conditions directly rather than indirectly via the banks.

Once again, there are some complications with such an approach. First, the increase in long-term liquidity provided through the VLTROs did not translate fully into higher sovereign debt holdings on bank balance sheets (though, in some member states, there was a high correlation between the two). Second, the ECB has committed to maintain fixed rate and full allotment for all its refinancing operations beyond the expiry of the VLTROs in February 2015 (out to July 2015). So the reduction in long-term liquidity due to the spring 2015 expiry could be compensated for by subsequent borrowing in other ECB operations. Third, the ECB could yet decide to introduce another VLTRO to counteract any tightening of money market conditions (perhaps with a fixed or capped rate to encourage take-up).

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Comparison with other central banks Could we use the methodology adopted by other central banks in their purchase programmes as a framework for predicting what the ECB will do? Again, there are some complications.

In the case of the Federal Reserve, for example, its asset purchases were initially concentrated in the mortgage sector (see Appendix 1). The initial purchases of Treasuries from March to October 2009 were comparatively modest, amounting to USD 300bn, which equates to roughly 2% of US GDP. The equivalent amount in the euro area would be a little under EUR 200bn. An additional USD 600bn of Treasury purchases then followed, again over an eight-month period, running from November 2010 to June 2011. Cumulatively, therefore, the Fed bought Treasuries equal to around 6% of US GDP over a period of 16 months.

The corresponding figure for the euro area would be around EUR 570bn (ie, 6% of GDP). If we then scale this down to a period of one year (the length of the ECBs two Covered Bond Purchase Programmes), this would imply ECB purchases of around EUR 475bn.

The Fed, however, was also buying huge amounts of mortgage-backed securities (MBS). From January 2009 to August 2010, it bought USD 1.25trn of MBS, well in excess of the scale of its Treasury purchases initially. To date, of the Feds asset purchases of USD 3.3trn since 2008, equivalent to around 20% of US GDP, around 55% have been in Treasuries.

The Bank of Englands purchases of gilts were, in relative terms, much bigger than those of the Fed in the early stages. Its initial programme in March 2009 was to buy GBP 75bn, equivalent to around 5% of UK GDP, over a period of just three months. By November the same year, it had added three further programmes, implying total purchases of GBP 200bn, equal to around 13% of GDP. The cumulative purchases to date of GBP 375bn equate to about 25% of UK GDP.

The equivalent ratios for the euro area would imply an initial purchase programme for the ECB of EUR 475bn. Total purchases would be a staggering EUR 2.4trn, which highlights just how large the Bank of Englands gilt purchases have been.

Another interesting aspect of the Bank of Englands experience is that, while it was able to buy private sector assets, in practice it bought very few. Its purchases were heavily concentrated in the sovereign debt markets. In practice, the end result may be similar for the ECB. While it may prefer to buy in other markets, the comparative depth of the sovereign markets implies that they are the most effective route to have a significant impact on monetary and financial conditions.

Bottom line As the various methodologies above illustrate, predicting how the ECB would set the size of a future asset purchase programme is more art than science. It is not obvious which framework, if any of the above, the ECB would favour. But the analysis does give us some pointers.

In terms of scale, weighing up the various estimates, we would expect ECB purchases to be in the region of EUR 300-500bn, equivalent to roughly 3-5% of euro-area GDP. Were the ECB to lean towards insufficient money growth as a framework for future asset purchases, this would dovetail with its two pillar monetary policy strategy and the use of money and credit trends as a cross-check for the medium-term assessment of risks to price stability. However, which method the ECB would chose to adopt is very uncertain.

Which assets to buy, how quickly to buy them and in what scale are, of course, inter-linked and for the ECB there is the additional problem of buying in heterogeneous markets. As Table 1 in Section 4 illustrates, if we assume the ECB buys EUR 400bn (the mid-point of the range above) in sovereign debt markets with maturities of up to ten years, on the basis of capital key weights, the ECB will end up holding significant but not dominant shares of outstanding debt in most euro-area member states. But if the maturity is limited to three years, the purchases will potentially dominate some markets. This may cap how much the ECB is willing to buy.

One way to try and lessen this problem is to lengthen a purchase programme. The periods in which other central banks have implemented their programmes have varied considerably and, again, there is no obvious benchmark to follow. The one-year length of the Covered Bond Purchase Programmes is a potential benchmark for the ECB but the Fed and Bank of England programmes were shorter.

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3. Private sector assets or sovereign debt? Complements rather than alternatives

Central banks are generally reluctant to buy government bonds and the issues for the ECB are more complex than for others. ECB President Draghi has expressed a preference for the ECB to buy private sector assets, with appropriate credit enhancement, for good reasons.

In targeting private sector assets, the ECB may get closer to the root of the problems which it is trying to address. The creation of an active ABS market in the euro area would allow banks to free up their balance sheets, facilitating new lending and effectively easing monetary policy by re-opening the credit channels through which it operates. However, there are obstacles in terms of technical complexity, pricing and the quantum of available assets.

We conclude that some purchases of private sector assets will be possible, but not in sufficient quantities, especially in the short term, to ease monetary conditions sufficiently. The ECB will find, as have other Central Banks, that it will also have to turn to the sovereign debt markets to find the depth and liquidity required for purchase programmes of meaningful size and impact.

For the ECBs QE programme, therefore, private sector asset purchases would be a complement, not an alternative, to purchasing euro-sovereign bonds.

The attraction of private sector assets for the ECB While we believe that a sovereign debt-focused programme would be most effective from the perspective of easing euro area monetary and financial conditions, buying private-sector assets may be a more likely first step for the ECB. It would be more palatable to the sceptics on the Governing Council, particularly if the purchases were targeted towards assets such as Asset-Backed Securities (ABS) based on SME loans. We know that improving financing conditions for smaller businesses (which create most of the jobs in the euro area) has been a recurring theme of discussions among euro-area policymakers for some time now. Focusing on this area would be a comparatively easy sell for the ECB. Measures to limit the risk taken onto the ECBs balance sheet would also increase the attraction of this option.

The disadvantage of buying private sector assets One of the drawbacks of buying private-sector assets, however, is the lack of deep markets in which to buy. This would limit the scale of any such purchases which, in turn, would hinder the effectiveness of the policy as a key transmission channel, the exchange rate, would not be impacted significantly. An ECB commitment to buy would, over time, help to stimulate the development of the ABS market in the euro area and would provide a welcome diversification of funding sources for corporates, reducing their traditional reliance on bank loans. But this is a longer-term goal. Beyond an initial announcement effect, we would expect only a limited impact on monetary and financial conditions.

As we discuss below, we believe the available pool of private sector assets that the ECB would be able to buy will fall short of the 300-500bn we think likely will be the size of an initial ECB QE programme.

The ECB will buy both private sector and sovereign bonds We conclude, therefore, that the ECB will find, in common with other central banks, that as well as buying private sector assets, it will have to turn to the sovereign debt markets to find the depth and liquidity required for purchase programmes of meaningful size and impact. Simply put, private sector asset purchases will be a complement, not an alternative, to purchasing euro-sovereign bonds.

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What private sector assets could the ECB buy? In this section, we assess the capacity for outright ECB purchases by asset type, as well as the economics for potential new securitisations, as follows:

- We compare the existing sizes of the covered and corporate bond, securitisation and SME loan markets.

- We examine the ECBs risk appetite and the potential role of the EIB/EIF in mitigating the ECBs risk exposure.

- Covered bonds where we believe purchases no longer make much sense.

- Corporate bonds constrained by credit quality.

- Securitisations and bank balance sheet SME loans: currently, there are constraints limiting the quantity of assets that the ECB would be able to purchase, but the ABS market will develop with potential guarantees from the EIB/EIF.

Outstanding sizes of covered bonds, corporate bonds, securitisations and SME loans To examine potential purchases of private sector assets by the ECB we consider the existinguniverse of covered bonds, corporate bonds and Asset Backed Securities (ABS), as well as SME loans currently sitting on banks balance sheets. We restrict ourselves to euro-denominated securities. Table 1 provides a summary of the outstanding notional amountsacross these asset types as well as a breakdown of the various securitisation types.

Table 1: European, -denominated outstanding notional amounts by asset type (bn)

Asset Type Amount Securitisation Type Amount Covered bonds 907 ABS 197 Corporate bonds 2,075 CDO 146 Securitisations (placed) 733 CMBS 102 Securitisations (retained) 812 RMBS 908 Bank corporate loans 4,000 SME 131 WBS 60 Total 8,528 Total 1,544 Source: AFME, Dealogic, BNP Paribas

At first glance, the 8.5tn sum might imply significant capacity for ECB involvement, however, as we set out below, credit risk constraints and securitisation economics and implementation complexities are impediments to large-scale intervention in the short-term. However, an ABS market should develop relatively quickly.

ECB appetite for risk and EIB/EIF involvement Historically, the ECB has purchased covered bonds (via the Covered Bond Purchase Programmes CBPPs) and sovereign debt (via the Securities Markets Programme - SMP) but not credit risk. The current haircuts applied for ECB repo operations reflect a low appetite for risk by the ECB and it is highly questionable whether they would be willing to buy outright anything but the highest quality and shorter maturity assets. Notably, ABS with a credit quality of BBB+ or lower are not eligible for repo at all, whereas higher rated ABS have a 16% haircut applied. One approach, which may broaden the scope of potential ECB purchases, would be for the European Investment Bank (EIB) or European Investment Fund (EIF) to provide guarantees to certain securitisations of bank assets. In fact, a number of joint Commission-EIB initiatives have already been put in place in recent years to boost financing for SMEs (namely the Competitiveness and Innovation Programme [CIP], the European Progress Microfinance Facility, The Risk Sharing Instrument Facility [RSI], and the Joint European Resources for Micro to Medium Enterprises [JEREMIE]). Most of these initiatives are managed by the EIF on behalf of the EC/EIB.

The EIF is indeed the specialist arm for SME risk financing within the EIB Group. It is 62% owned by the EIB, 30% by the EU (represented by the EC) and 8% by 24 financial institutions in

11


EU Member States and candidate countries. Its mandate is to help SMEs in the EU and candidate countries access finance by providing, through financial intermediaries (e.g. funds, commercial banks, leasing companies and microfinance institutions): (i) guarantees and credit enhancement/securitisation; (ii) private equity (venture and capital growth); and (iii) to a much lesser extent, microfinance. By offering guarantees and credit enhancement, the EIF protects its financial intermediaries capital by sharing the risk taken, with a view to stimulating and increasing the volumes of loans they grant to SMEs. For instance, total outstanding guarantee commitments amounted to 4.7bn as at end 2012 (2.6bn under EIFs own resources, 2.1bn under mandate programmes), catalysing a total of 32bn.

Going forward, there have been a number of comments from policy makers and the ECB about other initiatives to revive the Structured Credit market and increase SME lending even more (some of these options blend EU budget and European Structural and Investment Funds [ESIF] resources with the lending capacity of EIB, EIF and national promotional banks and would create 55-100bn new SME lending by 2020). While these options may remove the credit risk hurdle for the ECB to buy credit risk, it does however raise technical difficulties as well as numerous uncertainties pertaining to the cost of the guarantees and both rating and capital implications for the EIB/EIF. Furthermore, implementing such options will take time, while the expected deduced increase in lending might be too small for the ECB to conduct large-scale purchases for QE.

Covered Bonds purchases no longer make much sense It is indeed difficult to see how the purchase of covered bonds could make much sense under an ECB QE scenario. Although the market is fairly large and the ECB has been more comfortable with buying covered bonds (or accepting them as collateral) compared to senior bank bonds or ABS/MBS, the way the previous programmes were conducted make it difficult to generate large scale purchases.

There is no requirement for the ECB to distribute asset purchases across member states on the basis of GDP or capital key weights. There may, however, be a preference to do so if buying debt in the sovereign markets, given one aspect of the German Constitutional Courts opinion on OMT was that it contravened the singleness of monetary policy. If the ECB opted to use capital key weighting for non-sovereign asset purchases, this would mean that the ECB would have to spend the largest part of its money on German Pfandbriefe. This market has been shrinking for at least ten years, so it may be actually very difficult to even source enough material in the market in order to buy a significant amount of Spanish, Italian and other covered bonds.

In the past, the ECB was not willing to buy complete covered bond tranches in the primary market. At most, it would participate to a maximum of 15%-20% in a new bond issue. Secondary markets are already rather illiquid and it will be tough to source enough purchase volume in the primary market if the ECB were to apply this purchase mode in a QE scenario. If they decide to buy full tranches directly from single issuers, the decision from which bank to buy could have at least theoretically some competition implications

The ECBs second covered bond purchase programme was announced in October 2011 with purchases starting one month later. As with the first purchase programme, this one was set to run for 12 months but total size was only 40bn instead of 60bn. Of that 40bn the ECB only used 16bn within the 12 months of the duration of the programme. Shortly after the second purchase programme was launched, the ECB announced the first LTRO, which resulted in a significant market recovery as well as reduced covered bond issuance activity, by peripheral banks in particular. As the aim of the purchase programme was not to fight disinflationary tendencies in the eurozone but to provide banks with better access to funding, the success of the LTROs rendered the purchase programme redundant before it was fully utilised.

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Chart 1: German Jumbo Pfandbriefe net supply

Source: BNP Paribas

Finally, there is already a shortage of covered bond paper, which has led to significantly tighter spreads. Consequently, we believe that a new purchase programme would have limited impact on both issuance and underlying loan demand.

Corporate Bonds constrained by credit quality Table 2 breaks down euro-denominated corporate bonds issued by eurozone-based companies into credit quality and maturity buckets. This table is based on bonds in the iBoxx Investment Grade Corporate Bond Index, which contains the more liquid, benchmark-size issues (hence the smaller total than in Table 1). Arguably this is where the ECBs attention would be focussed should they embark on a corporate bond purchase programme.

Table 2: Outstanding -denominated corporate debt in the iBoxx IG Corporate Bond Index (eurozone-based issuers, bn)

1-3y 3-7y 7-10y 10y+ Total AA 28 43 19 6 96 A 80 149 90 19 339 BBB 96 212 86 10 404 Total 204 404 195 35 838 Source: Markit

What stands out is the limited amount of paper available at the top end of the risk spectrum. Only 11% (96bn) of outstanding issues in the index is AA rated, while there are no AAA bonds. The majority lies in the BBB bucket. This severely restricts the volume of bonds that the ECB could buy, assuming an unwillingness to weaken Central Bank balance sheets with lower quality assets.

Poor market liquidity and the supportive prevailing supply/demand technical, means that a significant spread compression could probably be achieved for a small amount of expenditure. Would this achieve the desired effect? Despite relatively low liquidity, the European credit market is functioning reasonably well. European corporates already have good market access, record low levels of funding and a good amount of cash on their balance sheets, however, they remain relatively cautious (the generally credit-defensive nature of corporate actions over recent years stands testament to this). Lowering the cost of funding further from current levels will therefore, in our opinion, be of limited use in accomplishing the goals set out at the beginning of this article.

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Securitisations and bank balance sheet SME loans European securitisations (including all types of collateral) amounted to 1,545bn at the end of Q3 2013, of which just over half (812bn) were retained by banks for repo with the ECB. Targeting their purchases at retained securitisations would have the dual benefits of converting repo-based liquidity to permanent financing (thereby reducing future liquidity risk) and advancing bank deleveraging. However, only 131bn, less than 10% of existing European securitisations, are collateralised by SME loans, therefore if the ECB wishes to focus on SME funding rather than mortgages, they may be better off approaching the much more substantial 4tn total of corporate loans on European banks balance sheets. Furthermore, with a typical SME senior tranche trading at 175-200bp and typical senior RMBS tighter (e.g. Dutch 60-70bp, Italian 100-150bp), the capacity to tighten spreads is greater with the former. However, of the 4tn corporate loans, only 18% (720bn) are to SMEs (according to the EBA Transparency data). In addition, these figures include non-European assets. Using pure domestic loans for each bank, the SME lending book would amount to around 576bn. To illustrate recent transactions, last month UniCredit announced that it would offload some junior and mezzanine risk on a 910mn portfolio of Italian project finance loans to Mariner, in order to release capital. It would free up c. 400mn RWA, releasing about 40mn of equity (relatively small), assuming the bank needs to have broadly 10% CET1 ratio. January also saw the issuance of a 437.5mn ABS of SME loans in Portugal. However, this was a short maturity and may have been done largely for funding reasons.

One issue for the ECB to tackle would be ensuring adequate credit protection or subordination. For the banks, on the other hand, reducing the cost of senior funding and/or selling mezzanine risk to attain sufficient risk transfer are crucial for the funding benefit and capital relief economics to work. As discussed above, one way to overcome these hurdles is via the provision of guarantees to benefit investors in SME securitisations.

The European Commission and the EIB are exploring a joint risk-sharing mechanism to be developed under the new MFF (Multiannual Financial Framework) by blending EU budget resources (COSME, Horizon 2020) and ESIF (European Structural and Investment Funds) resources with the lending capacity of EIB, EIF and national promotional banks. The key to unlocking the leverage effects for such Joint Instruments is the widest possible participation by Member States.

The Commission has developed three broad options for Joint Instruments to revive the securitisation market: (i) a joint SME guarantee instrument combined with a joint securitisation instrument for new loans, which would pool funds from COSME and Horizon 2020 (420mn) and the ESIF (10bn), with resources of the EIB and EIF, to provide a combination of guarantees for new SME lending by financial intermediaries and guarantees for portfolios of new SME loans for the purpose of securitisation, which portfolios would need to be built (2-3 years); this initiative is expected to create 55-58bn in SME lending over 2014-2020; (ii) a joint securitisation instrument allowing for securitisation of both new and existing SME loan portfolios, under which public funds (10bn from ESIF, 420mn from COSME and Horizon 2020, plus funds from the EIF, EIB and national promotional banks) would be combined for the securitisation of portfolios of SME loans; this is believed to boost SME lending by 65bn; and (iii) a Joint securitisation instrument allowing for securitisation of new and existing SME loan portfolios and risk pooling, believed to boost SME lending by 100bn. For more information on these proposals, follow the link:

http://ec.europa.eu/europe2020/pdf/eib_en.pdf

The EIF itself details two proposed approaches (see SME Loan Securitisation 2.0 Market Assessment and Policy Options, EIF, October 2013). The first is a guarantee facility, under which EIF would provide partial guarantees of up to 80% for new SME loans. The second is the joint securitisation instrument also mentioned above. With the guarantee facility, only new loans would be guaranteed, while with the joint securitisation instrument all existing loans could be guaranteed.

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EIF envisages synthetic senior and mezzanine risk transfer, with the originator retaining a portion of the First Loss Piece in order to align bank loan origination incentives with the interests of investors, in accordance with regulatory risk retention rules. Attractive senior and mezzanine funding rates would be provided to the banks, under the expectation that these are reflected in new loan agreements.

We estimate that full guarantees could reduce senior funding from 175-200bp down to 40-50bp and mezzanine from 400-500bp to 50-70bp, levels which we expect would generally facilitate the risk transfer. However, the extent to which, politically and financially, the EU may be willing to engage in such subsidies will be key, especially bearing in mind that the EIB/EIF are EU institutions, rather than purely eurozone ones. While new SME loans could be used, demand from SMEs would generally be for longer-term funding (5y), while the ECB may want shorter dated assets. It is worth noting as well that, since the banking crisis, the subordination has increased for securitisation transactions. Typical tranching is now as follows: 50% senior, 30% mezzanine and 20% equity. It is thus harder for such transactions to make economic sense. Hence, a policy action via the EIB, EIF or other multinational entities is critical to developing the ABS market.

Neither the EIB nor the EIF are subject to banking regulations, but Fitch notes that they both abide by stringent self-imposed concentration, liquidity and capital rules. For example, the EIF portfolio of own-risk guarantee commitments is limited to 3x subscribed capital. EIF subscribed capital currently stands at 3bn, implying a guarantee limit of 9bn unless capital is increased (EIB subscribed capital is around 242bn). However, we cannot exclude that with strong political support to help with the SME funding situation, such limits could be expanded.

Finally, while both Basel III/CRD4 and Solvency II have penalised securitisation, there have been recent efforts to soften the blow to SME financing. For example, Article 44 of the CRR provides that capital charges for exposures to SMEs should be reduced through the application of a supporting factor equal to 0.7619 to allow credit institutions to increase lending to SMEs. Further regulatory relaxation could further reinforce the development of an ABS market.

Conclusion

The development of the ABS market would be a complement to, not a substitute for, asset purchases by the ECB itself. The reasons being:

The purpose of QE is to fight inflation by the ECB (temporarily) creating liquidity and transferring it to the private sector in exchange for assets (which expand the ECBs balance sheet). Development of a successful ABS market eases the credit channel, which is useful, but cannot increase the supply of excess liquidity: by construction, only the ECB can do that.

With inflation so low and the zero bound so close, the ECB needs to act quickly to prevent further deflation by expanding its balance sheet, as the Fed, BoE and BoJ have all done. It does not have the luxury of time to wait for the credit channel to gradually to repair itself.

As other Central Banks (the Fed, the BoE) have found, even where a liquid market in private sector assets already exists, only the government bond market is deep and liquid enough to enable the ECB to act effectively to expand liquidity by buying assets (and the ECB itself was unable to complete its Covered Bond Purchase Programme, despite the size and reasonable liquidity of the Covered Bond market).

The initiatives to develop a euro area ABS market would ease the monetary transmission mechanism by freeing up banks balance sheets for new lending: and if official participation can be appropriately targeted, the market is likely to develop quickly, as there are willing sellers in the Banking sector and willing buyers in the Insurance sector. However, while the development of this market can ease monetary conditions over time, it is likely to be a complement to, not a substitute for, buying of government bonds by the ECB because the government bond market remains the only practical venue for the injection of liquidity via large scale asset purchases, which is necessary to address the very immediate threat posed by eurozone disinflation.

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4. Which bonds, which maturities, which proportions?

We expect the ECBs purchases of sovereign bonds to be weighted by each countrys contribution to the ECBs capital. Purchases of private sector assets, perhaps including supranational and agency debt, are also likely. The ECB may want to limit its initial purchases to maturities of up to 3 years, as with the OMT framework. But purchases of longer maturity assets may be preferable, or may also become necessary later.

Buying in sovereign debt markets is, we believe, the most effective way to loosen euro-area monetary and financial conditions through the asset purchase route. Here we set out how we expect the ECB to choose which bonds to buy. We expect that:

QE buying will be capital-key weighted; and The initial buying will probably favour 1-3y maturities. SSA might well be included

Distributing purchases among sovereigns: Expect capital-key weighting As a result of the importance of monetary policy being conducted for the euro area as a whole, we think that the most appropriate way to distribute purchases is on the basis of member states capital contributions to the ECB. There would, presumably, be objections to large-scale buying of Bunds (from the Bundesbank at the very least), including the following:

German interest rates are already exceptionally low; Germany has no problem financing itself; A further easing of already very loose financial and monetary conditions in Germany

would run the risk of creating asset price bubbles; and

It would raise inflation more generally. But we think these arguments are outweighed by the need to buy bonds according to an objective standard. Furthermore, we would argue that raising inflation more generally should be one of the main objectives of the policy, as the adjustment of relative labour costs and prices in the peripheral countries of the euro area is occurring at too low a level of overall inflation. The ECB, to judge by recent comments on the issue, sees the risks associated with such an adjustment in much the same way.

Moreover, buying in the more secure, low-yielding markets is precisely what the ECB should aim to do as it would have positive effects through various channels, including portfolio shifts. By removing German debt from the market, the ECB would push investors into other assets, which would probably lower risk premia. This is how the portfolio balance channel of QE is supposed to work.

Distributing purchases among maturities: 1-3 years, or 1-10 years We think the ECB is likely to announce that its QE purchases would take place, as with the OMT framework, in bonds with maturities no greater than three years. Although some will object that part of the way QE works it to reduce real yields along the curve, there are three main arguments in favour of limiting purchases to the front end of the curve.

The three-year maturity appears to be the time limit with which the ECB is most comfortable when it comes to monetary policy initiatives.

As with the argument above in favour of buying Bunds despite their already-low yields, ECB buying in shorter maturities would encourage private sector buying further out along the curve.

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Buying only out to three years addresses one key objection to QE programmes, which is that by buying at long maturities risks leaving the central bank permanently bloated even after inflation returns to the target (for the ECB, such purchases also leave the central bank exposed to long-term credit risk). By limiting purchases to 1-3 year maturities, the ECB addresses this objection, because it can be certain that, from the day it stops its QE purchases, it will take only three years for the ECB balance sheet to return to its pre-QE size.

The greatest argument against limiting QE purchases to the front end of the curve may lie in issues of market liquidity. An asset purchase programme of EUR 400bn, only 4% of GDP, would still amount to some 32% of the outstanding 1-3 year euro sovereign market, as Table 1 shows. Even at a pace of EUR 30bn/month very modest by, for example, US or UK standards it would be a considerable flow for the market to absorb. This very fact might swing the ECB to decide to implement QE across a wider range of maturities: the same EUR 400bn would be only 10% of 1-10 year outstandings.

Table 1: Potential QE size versus market size

EUR bn QE/Outstanding EUR bn QE/Outstanding

Germany 27.1% 108 267 40% 766 14%

France 20.3% 81 257 32% 893 9%Italy 17.9% 71 344 21% 1021 7%

Spain 11.9% 47 170 28% 438 11%Netherlands 5.7% 23 80 28% 233 10%

Belgium 3.5% 14 53 26% 208 7%

Greece 2.8% 11 0 - 2 627%Austria 2.8% 11 25 45% 130 9%

Portugal 2.5% 10 19 53% 75 13%Finland 1.8% 7 12 62% 55 13%Ireland 1.6% 6 14 46% 70 9%

Slovakia 1.0% 4 7 58% 16 24%Slovenia 0.5% 2 2 85% 8 25%Estonia 0.3% 1 0 - 0 -

Luxembourg 0.2% 1 0 - 5 20%Cyprus 0.2% 1 1 134% 2 38%

Malta 0.1% 0 1 47% 3 12%Total 100.0% 400 1252 32% 3924 10%

ECB Capital key Adjusted to EU17

QE 400bn Allocation

1-3y Bucket 1-10y Bucket

Source: BNP Paribas

On balance, we reckon that the ECB will probably decide to distribute its buying using a capital-key weighting across 1-3 year maturity sovereigns. But we would add that we expect the portfolio balance effect would mean that investors would switch into longer maturities. Hence, the effect on yields along the curve may not be that different whether the ECBs initial buying extended to 3- or 10-year maturities.

Similarly, if the initial buying were to be distributed across a wider range of maturities than we expect, the effect on sovereign spreads should still be the same, in our judgement.

Purchasing SSA paper as part of QE makes sense, by the very nature of SSAs Given the size of the SSA market and the mandate of SSA borrowers, its quite likely that ECB QE would also include the buying of SSA bonds.

The typical mandate of an SSA (national agencies or supranationals) is to support growth in a given country (or countries), usually via the financing of small and medium-sized enterprises (SMEs). Germanys KfW, for example, is responsible for enhancing German economic development and lending to SMEs, state-owned enterprises and infrastructure investment projects. Spains ICO agency is responsible for supporting and fostering economic activities that contribute to Spanish growth; a major chunk of its loan portfolio goes to SMEs. OSEO, one of the French agencies, has a mandate to promote the development and financing of SMEs. And

17


the European Investment Bank (EIB), the EUs development bank, puts money into sound investment projects, mainly within the EU, with a view to promoting sustainable growth.

During the financial crisis, the role of SSAs in supporting financing for SMEs became even more crucial, as access to funding became increasingly challenging. There have been a number of initiatives over the years to improve SME access to funding in a bid to revive growth and job creation in Europe. Many are managed by the European Investment Fund (EIF) on behalf of the European Commission and EIB. There have also been agreements between SSAs. Take, for example, the KfWs EUR 800mn loan to ICO, or the ICO-EIB agreement, under which the EIB granted ICO a EUR 1bn loan, which ICO then topped up by another EUR 1bn, aimed at financing SME investment projects, among other things.

If the ECB were to buy SSA paper under QE, therefore, it would have the benefit of support entities actively funding the real economy.

European supras and eurozone agencies almost EUR 1trn of EUR benchmarks The SSA market is clearly not as deep as the sovereign debt market. Still, even if we exclude non-EUR and non-benchmark issues, the market remains significant and would give the ECB a good degree of diversification (Table 1). European supranationals account for EUR 706bn of outstanding debt, in all currencies, of which EUR 390bn are EUR-denominated benchmarks (EUR, fixed, with a minimum size of EUR 750m). Eurozone agencies account for EUR 1.1trn of outstanding debt, of which EUR 555bn are EUR-denominated benchmarks.

In 1-3y maturities, there are EUR 407bn of bonds, so the ECB could aim to execute a reasonable proportion of QE in SSAs. To the extent that the ECB did buy SSA bonds, the ECB would be able to argue more forcefully that its QE would not be monetary financing of governments.

Table 1: European supras and euro-area agencies outstanding debt (figures in EUR bn)All EUR bench 1-3y EUR bench

Supras 706 389 128Germany 582 241 131France 253 162 60Nether 131 47 24Spain 93 78 57Austria 45 24 7Finland 17 0 0Italy 6 2 1Belgium 2 0 0Total 1836 944 407EZ agencies 1130 555 279Supras 706 389 128

Source: BNP Paribas, Bloomberg

This document has been written by our strategy teams. It does not purport to be an exhaustive analysis, and may be subject to conflicts of interest resulting from their interaction with sales and trading which could affect the objectivity of this report. This document is a marketing communication. They are not independent investment research. They have not been prepared in accordance with legal requirements designed to provide the independence of investment research, and are not subject to any prohibition on dealing ahead of the dissemination of investment research.

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5. Implementation: Transparency versus opacity Central banks around the world have used a wide range of methods to implement

asset purchase programmes. The ECB has used various methods for its asset purchase programmes to date. Asset purchases aimed at delivering price stability in the euro area should be more akin to the format of the Covered Bond Purchase Programmes than the SMP.

The ECB has engaged in three asset purchase programmes since the onset of the financial crisis, not including the announcement of OMT in summer 2012. There have been two Covered Bond Purchase Programmes (CBPPs), starting in July 2009 and November 2011 and the Securities Markets Programme (SMP), introduced in May 2010. The programmes were different in a number of respects (Table 1).

Table 1: ECB asset purchase programmes Programme Announced Started Length Objective Scale (target) Maturities

(months) (EUR bn)

CBPP1 May-09 Jul-09 12 "Easing of funding conditions for credit institutions and enterprises."

60 (60) All

CBPP2 Oct-11 Nov-11 12 "To encourage credit institutions to maintain and expand lending to their clients."

15 (40) All

SMP May-10 May-10 21Address "severe tensions in certain market segments which hamper monetary policy transmission and effective conduct of monetary policy."

220 (n/a) All

OMT Aug-Sep 2012 n/a n/a "Safeguarding an appropriate monetary policy transmission."

0 (n/a) 1-3 year

Source: ECB, BNP Paribas

CBPP1 and CBPP2 both incorporated quantified, ex-ante targets for the volume of purchases to be made within the programmes, of EUR 60bn and EUR 40bn, respectively. A clear timeframe was also announced in advance of the purchases, with both programmes to run for a period of twelve months. Purchases were to be made in primary and secondary markets and distributed across the euro area, consistent with single monetary policy, with specific eligibility criteria laid out for the assets to be bought and the counterparties in the transactions.

http://www.ecb.europa.eu/press/pr/date/2009/html/pr090604_1.en.html

The first programme reached its target of EUR 60bn of purchases (roughly 0.7% of euro-area GDP). The second programme fell short of its target of EUR 40bn, reaching a peak of around EUR 15bn and was brought to a premature end following the announcement of OMT. Assets bought under the two programmes were held to maturity and proceeds were not reinvested.

According to the ECB, there were two key objectives for the CBPPs: first, to ease funding conditions for credit institutions and enterprises; and second, to encourage credit institutions to maintain and expand lending to their clients.

The SMP was announced in May 2010 to address the severe tensions in certain market segments which hampered the monetary policy transmission mechanism and thereby the effective conduct of policy oriented towards price stability in the medium term.

http://www.ecb.europa.eu/press/pr/date/2010/html/pr100510.en.html

Purchases were not quantified ex-ante but were to be determined by the Governing Council on a rolling basis and announced in the week following the transactions see Appendix 1. The interventions were sterilised, with weekly fixed-term deposits introduced to re-absorb liquidity injected via the SMP. The intention of sterilising the purchases was to ensure that the monetary policy stance will not be affected.

In the context of a fixed-rate, full-allotment procedure at all of the ECBs refinancing operations, we see the sterilisation of the SMP as ineffective in practice and as a presentational fig leaf. If, as we expect, a future ECB asset purchase programme is framed around the explicit goal of adhering to the primary objective of price stability, then sterilisation would be inappropriate and

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counterproductive. As highlighted previously, the second pillar of the ECBs monetary policy strategy is indicative of a shortfall of monetary growth in the euro area.

Indeed, the ECBs position on sterilisation of asset purchases seems to be evolving, with recent press reports suggesting that an end to SMP sterilisation is one of the options under discussion in order to slow the fall in excess liquidity and to ease money market conditions. That the press reports suggest that this option has Bundesbank support is also significant.

When conducting QE, other central banks have announced ex-ante targets for purchases to be made over a specific timeframe, more akin to the procedure for the ECBs CBPPs than to the SMP. The ECB would probably follow the former methodology rather than the latter if, as we expect, the asset purchase programme is aimed at ensuring price stability, with sterilisation of purchases rather unlikely in this context.

QE is not a monetary policy reaction to difficult funding conditions for governments. Therefore, the frequency of purchases matters and a scale and timeframe for purchases is required.

The following page sets out in a table the attributes of various asset purchase programmes by central banks.

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Table 2: Implementation of central banks asset purchase programmes

BOE BOJ ECB SMP

Obj

ectiv

es Inject money directly into the economy in order to boost nominal demand

Reach price stability target of 2% yoy (CPI), as soon as possible Time horizon of ~ 2y

Address the malfunctioning of security markets and restore an appropriate monetary policy transmission mechanism(it was part of a broader package decided to address severe tensions in financial markets)

Elig

ible

ass

ets

Treasuries: 97% nominal, 3% TIPS 4-30y (avg duration of 9y)

Agency MBS: Fixed rate Guaranteed by Fannie Mae, Freddie Mac, Ginnie Mae (Purchases likely to be concentrated in newly-issued agency MBS, for their greater liquidity & close tie to primary mortgage rates)

Conventional Gilts (only, linkers excluded): 3-55y Gilts Avg duration of 9.6y

JGBs: JPY 101tn projected over 2y - avg remaining maturity of 7y The BoJ also purchases T-Bills, CPs, corporate bonds and risk assets (ETFs, J-REITs) but in smaller size (JPY 31tn projected)

Sovereign assets for the most (if not all), although interventions were supposed to focus on both public and private debt securities markets May 2010/early 2011: purchases mainly concentrated on Greece, and to a lesser extent on Ireland and Portugal (2-10y maturities) July 2011: aggressive purchases of Italian and Spanish assets

Exce

ptio

ns &

Hol

ding

Lim

its

Excluded: Cheapest to deliver securities Heightened scarcity value in repo market STRIPS

Holding limit: SOMA ownership of a given security may not exceed 70% of the security's outstanding amount

Excluded: CMOs, REMICs, Trust IOs/Pos other mortgage derivatives or cash equivalents

Excluded: index-linked gilts rump stocks stocks with an outstanding below 4bn initially conventional gilts with maturities 25yrs were excluded but this was changed to include 3y+ maturities. Holding limit: Bank of England would not buy any gilts where it holds 70% of the free-float already.

Excluded: Cheapest to deliver securities for 1st and 2nd JGB futures Bonds not issued on the BOJ programme's settlement dates

Rei

nves

tmen

t Maturing Treasuries are reinvested into new issues at auction

Principal payments from the Fed's holdings of agency debt and agency MBS are reinvested into agency MBS

Maturing Gilts have been reinvested across the curve in the typical buckets (shorts, mediums, longs) under forward guidance. Subject to monetary policy variable decision ahead.

No reinvestment in principle, but the direct purchasing amount of one-year bills from the MoF(Rollover) is decided ahead of each fiscal year.

Met

hodo

logy

Schedule tentative schedule is published on or around the last business day of prior month to the following month's operations (each month, the Desk anticipates conducting 18 operations, of which 1 for TIPS)

Offer process competitive offer process - offers evaluated on their proximity to prevailing market prices at the close of the auction, as well as on measures of relative value calculated using the FRB NY proprietary model primary dealers submit offers for themselves and their customers: 9 offers per issue on a range of eligible securities

Schedule the amount to be purchased is announced on or around the last business day of prior month Purchases are conducted on a frequent basis over the course of each month, guided by MBS market conditions, including supply and demand conditions, market liquidity, and market volatility

Offer process competitive offer process primary dealers submit offers for themselves and their customers.

Schedule The BoE normally conducted 3 auctions a week: 3-10y gilts on Monday, 25y+ on Tuesday and 10-25y Wednesday. Stock Allocation Process at Reverse Auction: The amount of each gilt purchased will not be pre-determined, subject to the overall size of the operation. Offers for different stocks will be allocated based on the attractiveness of offers for each stock relative to market yields for the stocks, as published by the DMO, at the close of the auction. There will be no minimum allocation to a particular stock.

Schedule operations are not conducted everyday but are announced by the BOJ at 10:10 JST the very same day it conducts the purchases

Offer process competitive bidding based on the yield (or price for Floaters and Linkers) difference from the prior business day

OTC: NCBs dealt with MFIs

Sterilisation (not QE)7-day term deposits are conducted on a weekly basis to re-absorb the liquidity injected through the SMP, so that the monetary policy stance is not affected

Tran

spar

ency

Reported following each operation: total amount of propositions received total amount of propositions accepted amount purchased per issue weighted-average accepted price highest accepted price proportion accepted of each proposition submitted at the highest accepted price

Agency MBS transactions reported after settlement occurs. Weekly reporting of more detail including detailed data on all settled SOMA agency MBS holdings. Monthly (mid-month, for prior month) reporting of operational results, including information on the transaction prices in individual operations.

Reported following each operation: Total offers received (proceeds mn)Total allocation (proceeds mn)Total allocation (nominal mn)Allocation of which non-competitive (nominal mn)Weighted Average Accepted Yield (%) & PriceeHighest accepted priceAllocated at highest price (%)Lowest accepted priceTail

Regarding JBGs, BOJ announces at noon the transaction results, incl. total amount received, total amount accepted, and average and pro-rata yield spreads. But the purchased price remains unknown Individual bond holdings at the end-of-month is announced 2nd business day of the next month BOJ publishes purchased volume of ETFs and J-REITs after the market closes

No official communication:sizes, maturities and prices were unkown, as well as the breakdown by countryOnly the volume of purchases was indirectly known:through weekly term deposit operations conducted by the ECB to freeze the SMP

But in Feb 2013 (1y after the end of the SMP), the ECB published: remaining volume of bonds purchased per country (at end 2012) average remaining maturity per country (at end 2012)

Source: BNP Paribas

FED

(1) Maintain downard pressure on LT interest rates(2) Help make broader financial conditions more accomodative(3) Support mortgage markets

This document has been written by our strategy teams. It does not purport to be an exhaustive analysis, and may be subject to conflicts of interest resulting from their interaction with sales and trading which could affect the objectivity of this report. This document is a marketing communication. They are not independent investment research. They have not been prepared in accordance with legal requirements designed to provide the independence of investment research, and are not subject to any prohibition on dealing ahead of the dissemination of investment research.

21


6. Market implications The market implications of ECB QE are striking, especially in the periphery.

Moreover, the announcement effect is very important. Experience in the US, UK and Japan shows that markets move well ahead of the actual beginning of QE.

Thus, while we dont expect ECB QE to start before H2 2014, we do expect the market to re-price before then. Some implications are more difficult to assess than others. Our higher conviction views for end-H1 2014, ie before ECB QE starts, are:

Spain and Italy yields to fall 60-80bp and further after QE starts.

France-Germany spreads to fall to 10bp in 3y and to 50bp in 10y (a tightening of about 10bp across the curve) with further narrowing after QE starts.

Core yields to fall marginally until QE starts then to rise.

Breakeven inflation swap curve to steepen, with 5y5y swap breakevens rising.

Risks: What if, contrary to our expectations, the ECB begins to retreat from eventual QE? If the ECBs reason is upside surprises to inflation and growth, we think our expectations would still likely be fulfilled, albeit at a slower pace.

QE: The announcement effect The experience of QE in the US, UK and Japan has been that the market re-prices before QE is implemented, and even before it is formally announced (charts 1-4). The lesson we draw from this is that if the ECB is moving towards QE, investors should not wait for its implementation, or even its formal announcement, before positioning appropriately. We expect QE to be implemented during H2 2014 but that means, we believe , that market pricing will have largely

Chart 1: Gilts rallied before QE started in 2009 Chart 2: JGBs rallied before Kurodas appointment

Source: BNP Paribas Source: BNP Paribas Chart 3: Hard to disentangle US QE1 from rate cut Chart 4: Easier to see US QE2 announcement effect

Source: BNP Paribas Source: BNP Paribas

22


discounted it by the end of H1, as the ECB moves towards a formal announcement and implementation of asset purchases.

Market implications of QE - rates The implications of QE for the Eurozone rates markets trades are more difficult to judge in some areas than in than others.

The following table summarises our expectations.

Table 1: Expected market impact of the anticipation and implementation of QE

now end-H1 2014 (pre-QE) end-H2 (QE under way)

10y yield level (swap rate) 1.90% 1.80% 2.05%Bund asset swap -26bp unclear unclearcore/ semi-core asset swap (FR 10y) 36bp 25bp 5bpSP/IT yield (10y average) 3.55% 2.95% 2.85%5y5y BEI (swap) 2.12% 2.20% 2.30%cash-swap breakeven inflation (10y FR, IT) -30bp, -65bp unclear unclear

We think the most straightforward implications of QE are that peripheral yields should fall, that semi-core spreads versus swaps should narrow, and that the breakeven inflation swap curve should steepen, led by rising 5y5y forward inflation.

On the other hand, in our view the implications for the level of 10-year yields, for Bund asset swap spreads and for bond inflation breakevens relative to swaps are quite difficult to assess.

More straightforward implications for rates Peripheral spreads should fall because of (1) ECB buying creating a supply/demand imbalance, (2) a portfolio balance effect resulting from lower core yields, particularly at the front end of the curve (3) the implicit reduction in the near-term probability of default and (4) better debt dynamics caused by the combination of higher expected nominal growth and lower current yields.

As table 2 shows, we expect a two-stage narrowing of spreads: first, at the end of Q2, a 50-60bp narrowing based on the announcement effect and in anticipation of QE and, second, a further 30-40bp reduction when QE buying actually takes place in Q3. On our forecasts, this will lower 10y peripheral spreads to 100bp for both Italy and Spain towards the end of the year.

Table 2: BNPP peripheral spread forecasts (bp)

Current Q114 Q214 Q314 Q414 Q115 Q215 Q315 Q415Italy 195 195 130 100 100 110 110 115 120Spain 190 190 140 100 100 110 110 115 120

Current Q114 Q214 Q314 Q414 Q115 Q215 Q315 Q415Italy 195 0 65 95 95 85 85 80 75Spain 190 0 50 90 90 80 80 75 70

10-year spreads to Bund

Levels

Changes from Current

10-year spreads to Bund

Source: BNP Paribas

These forecasts are based on our central scenario of a EUR 300-500bn QE programme over one year with purchases of sovereign debt in the 1-3y maturity bucket. To arrive at our 10-year spread expectations, we assume a level for peripheral 3y spreads versus Germany given that the ECBs purchases are likely to occur on the short end of the curve. We set our target for 3y Italian and Spanish spreads versus Germany at 40bp, which is around 10bp wider than the current level of 3y Belgian spreads. We then used four different methods to calculate implied 10y spreads versus Germany. These are summarised in Table 3.

23


Table 3: Framework for implied 10y spreads based on post-QE 3y spreads (bp)

Current 3y Spread

Current 10y Spread

Post QE 3y Spread

1) Based on pre-crisis beta

2) Based on SMP 2.0

3) Based on OMT

4) Based on unchanged fwds

Italy 130 195 40 62 119 138 153Spain 129 190 40 54 111 137 148

Implied 10y spreads by each method

Source: BNP Paribas Method 1 Using the pre-crisis beta: In this method, we look at the historical relationship between 3y and 10y spreads to Germany. In other words, we monitor the sensitivity of the 3/10y box versus Germany to the level of 3y spreads (Chart 5). We are using a long sample period, between the years 2000 to 2014, as we have to go back to the pre-crisis period to find 3y spreads as low as 40bp. This method is the most aggressive, as it completely ignores both the starting point and change in spreads. This method should work as a guide for the minimum level of 10y spreads once the ECB starts purchasing bonds.

Methods 2 and 3 Using the experience of previous ECB direct and indirect interventions: Essentially, we focus on what happened in response to the SMP2 and OMT announcements. For these periods, we estimate the beta of 10y spreads versus Germany for a given change in 3y spreads versus Germany. During SMP2, when the ECB was mainly buying paper in the 1y-10y part of the curve, the narrowing of the 10y spread versus Bunds amounted to 84-89% of the 3y compression, ie, the curve bull steepened slightly (Chart 6). After the announcement of OMTs, through which the ECB would buy paper on the 1y-3y part of the curve, the narrowing of the 10y spread versus Bunds was much smaller at just 59-63% of the reduction of 3y spreads (Chart 7).

Chart 5: 3/10s ITA/GER box versus 3y BTP/Bund spread Chart 6: Changes in peripheral spreads during SMP2

-118 -115-108

-97

-57

-108 -107-102

-95

-60

-140

-120

-100

-80

-60

-40

-20

0

2y 3y 5y 10y 30y

SMP2.0Impact August2011

ITA

SPA


Chart 7: Changes in peripheral spreads due to OMTs Chart 8: Implied 10y spreads using unchanged forwards (bp)

-282 -290

-255

-184-143

-336 -331

-285

-194

-130

-400

-350

-300

-250

-200

-150

-100

-50

0

2y 3y 5y 10y 30y

OMTImpact July September2012

ITA

SPA

0

50

100

150

200

250

3y 3y7y 10yCurrent ITA/GER Current SPA/GER Post QE ITA/GER Post QE SPA/GER

QEImpacton3yspreads

Unchangedforwards


24


In the event of QE, we believe that the beta should be somewhere between those of SMP2 and OMTs. The rationale is that even though we expect the ECB to buy sovereign debt in the 1-3y part of the curve, so looking much more like OMTs, we should see a substitution effect throughout peripheral curves. This is because, in contrast to SMP2 and OMTs, the ECB will also be buying even larger amounts of German and French paper. We expect peripheral curves reaction to be non-linear, ie, we expect bull steepening around the time of the announcement, and bull flattening later on as purchases are made.

Method 4 Assuming unchanged forward yields: This method is the least bullish, as it assumes that only the 3y spread to Germany collapses, to 40bp, while the 3y7y forward spread remains unchanged, resulting in less narrowing of the 10y spread than previous methods (Chart 8). This is the least aggressive method as it does not assume any broad-based risk-on sentiment or substitution effects. It only takes into account the fact that a new large buyer will emerge on the 1-3y sector, causing 3y

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