The Bad Consequences of ECB Bond Purchases Become Visible

 | Aug 11, 2017 | 8:00 AM EDT
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Investors concerned that the European Central Bank (ECB) soon may need to wind down its asset purchases have one more reason to worry: The negative consequences of the central bank's quantitative easing program are beginning to be seen.

The idea behind the ECB's purchases of bonds -- and particularly corporate bonds, announced in March 2016 -- has been to lower the cost of borrowing and thus encourage companies in the eurozone to invest and create jobs.

Up to a point, this idea has worked. Unemployment in the euro area keeps falling; it was 9.1% in June, the lowest level since February 2009. Companies in Europe are at the forefront of a revival in capital expenditure, which is rising by 10% in Western Europe compared with 4% in North America, according to the S&P's global corporate capital expenditure survey for 2017.

However, together with the ECB's policy of negative interest rates, the bond purchases have pushed many investors into assets that are perhaps too risky for their taste in ordinary times. Recent analysis by Bank of America Merrill Lynch shows that individuals and companies in the eurozone may be shifting money away from bank deposits and into corporate bonds.

Bank deposit interest rates have been falling since March last year, when the ECB introduced its 0.40% negative interest rate for commercial banks' deposits. That action forced banks to cut the rates they offer to their own depositors or even, in some cases, try to charge them for holding their money. This situation is pushing individuals toward riskier asset classes.

"With household deposits having grown to near €7.0 trillion ($8.22 trillion) in the eurozone, we doubt this source of corporate bond buying will switch off any time soon," the analysts at Bank of America Merrill Lynch wrote in their report.

European corporations are also likely exacerbating inflows into corporate debt. Their return on cash in the bank has dissipated, too, with almost 19% of German firms saying in a survey that their banks have tried to charge them for their cash deposits. In response, companies have tried to diversify away from bank deposits; many of them invested in ... corporate bonds.

This is likely to continue for a while. "Given that the cash on the balance sheet of the German corporate sector is currently €195 billion, and that we estimate their 2018 free cash flow is likely to be €66 billion, just this sector alone could materially add to the weight of new money coming into euro credit," the analysts said.

It's not just corporate bonds. The asset price bubble widens, with some companies borrowing cheaply in the bond market using the proceeds to buy back shares rather than invest and create jobs like the ECB would want to see.

The MSCI Europe Buyback Yield Index reflects the performance of companies that return capital to shareholders through share buybacks. It includes large- and mid-cap stocks across 15 European countries: Austria, Belgium, Denmark, Finland, France, Germany, Ireland, Italy, the Netherlands, Norway, Portugal, Spain, Sweden, Switzerland and the U.K.

The performance of the index took off since the ECB started buying corporate bonds in June last year. This could be a sign that companies are using the cheap debt, at least in part, to finance share buybacks.

These two phenomena -- diverting cash from bank accounts into corporate bonds and companies financing share buybacks with debt -- are harmful over the long term. They make the financial system less stable. They also move resources from the real economy into financial speculation -- not really the stuff that creates jobs. Their growing visibility may be a sign that ECB tapering is just around the corner.

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