ECB Tapering and the Government Funding Gap
The ECB has been a significant buyer of government debt in recent years. This has supported wide government deficits in the Euro Area, most notably in Italy, Spain and France (60% of government debt in the region). With Euro Area inflation now 7.5% (March 2022), the ECB is expected to taper its QE programmes and attempt to raise interest rates later this year. This piece explores the consequences of ECB tapering and considers if the government funding gap will be covered.
The objective of Carraighill research is to understand the environment within which our companies operate in as much detail as possible. Our analysts can then undertake detailed fundamental work on specific companies, with a clear understanding of the ecosystem. The likely path of ECB policy has clear implications for banks, REITS, fintech, homebuilders and asset management firms.
Central Bank Holdings of Euro Area Government Debt
Between 2012 and 2020 the ECB purchased 88%, 61% and 54% of Italian, Spanish and French debt. The role of the ECB cannot be overstated. Without these purchases, government borrowing costs (yields) in these countries would be significantly higher.
In 2021 alone, the ECB increased ownership by 24% (Italy) and 30% (Germany).
This chart just illustrates the four main Euro Area countries. The ECB holds significant shares of debt in the other 15 Euro Area countries, most notably Greece, where it has been buying debt despite it lacking investment grade status. ECB tapering is a risk to many of these countries.
ECB Tapering and Forward Guidance
The ECB has lowered its QE purchases over recent months (primarily the PEPP). QE is now confined to the original APP programme. The ECB’s latest forward guidance is that it will purchase €40 billion in April, €30 billion in May and €20 billion in June. This implies that there will be no further purchases from July onwards. Markets are currently expecting the ECB to raise interest rates at the July meeting.
Added Borrowing Requirements and Funding Gap in 2022
One key issue in 2022 is the size of the funding gap as we begin ECB tapering. The war in Ukraine has clearly shifted the economic forecasts for Euro Area countries in 2022. Real growth is likely to be lower and CPI higher. The price shock is likely to provoke higher government spending as they mitigate the hit to household income. However, increasing CPI also supports higher government revenues as tax items such as VAT and excise rise instantly. Income tax receipts will only rise if wages rise.
To model wider deficits, we have considered the worst-case deficit forecasts from market analysts. These show an added borrowing requirement of €149bn in 2022 across the four main Euro Area countries. Germany has the largest added borrowing requirement (€88bn). This also relates to new government commitments to increase military and energy spending.
The added borrowing increases the “funding gap” for 2022 (the amount of debt which must be purchased by private buyers, after QE and NGEU loans/grants). We estimate it to be €373.0bn in 2022 and €414.6bn in 2023 (Euro Area 19 countries). This is significantly higher than the 2014 gap of €297.7bn.
What About Politics?
The weak Euro Area economy has been a source of political risk for the past decade. This is primarily because it is not an optimal currency area. The 2018 election in Italy saw the election of the first populist government in any of the four main countries. Confrontation with the European Commission over fiscal rules led to significant market volatility and a fall in Italian bank shares. Spain saw elevated political risk as the Podemos party entered coalition government in 2020.
Italy and Spain will hold elections in 2023. Two eurosceptic parties are performing well in opinion polls, Brothers of Italy and Vox (Spain). While neither can enter government on their own, their inclusion in coalitions heightens the risk of unpredictable policies.
ECB tapering runs the risk of increasing government borrowing costs. This subsequently lowers the potential for governments to support their citizens through this period of high inflation. It also lowers growth which may lead to higher support for these parties. Political risk should therefore rise.
Historic Periods with No QE
ECB tapering poses a risk to bond yields. However, there has been three recent years with no quantitative easing (2013, 2014 and 2019) and all coincided with falling yields. These episodes saw private buyers step in to buy the debt.
The first two years (2013 and 2014) followed Mario Draghi’s “whatever it takes” speech. The speech created a positive investor environment, leading foreign buyers to invest over €300 billion in Euro Area debt. The 2019 episode followed the 2018 Italian election crisis. Investors were relieved to see a resolution to the stand-off between the new populist government and the European Commission.
These two episode show that periods of private buying can exist amid ECB tapering. However, all were episodes of relief where investors saw an end to a recent crisis. Will history repeat itself?
Conclusion
ECB tapering comes with many risks. These include widening periphery yields, lower growth and political risk. Nonetheless, it is likely the ECB will end its QE purchases this year. The rate of inflation in Euro Area countries is now too high to ignore. We have written before about an eventual return to disinflation in the Euro Area. The structural forces driving this trend are still in place. However, they have been clearly delayed due to the war and persistent supply chain bottlenecks.
Once these issues pass, the ability of the ECB to significantly unwind these purchases (quantitative tightening) becomes very difficult. The future of the Euro Area looks similar to Japan, where the central bank has significant QE holdings for many decades.
This has clear investment implications across many of the companies that we review.
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