(This post is thanks to Editor Thorsten Beck)
The lead article in Volume 22, issue 1 of the Review of Finance is “ECB Policies Involving Government Bond Purchases: Impact and Channels” by Arvind Krishnamurthy, Stefan Nagel and Annette Vissing-Jorgensen. It is an analysis of the effect of three ECB policy programs on government bond yields and the real economy. Using an event study approach and disentangling different components of sovereign bond yields, this study helps us understand the effects of ECB interventions during the crisis on both banking and the real sector.
The ECB as Eurozone firefighter
At the height of the Eurozone crisis, with government bond yields of several Eurozone countries reaching unsustainable levels, the ECB introduced several programs to support the sovereign bond market:
- The Securities Market Programme (SMP) was announced in May 2010. This involved the ECB directly purchasing government debt of distressed countries, including Greece, Italy, Ireland, Portugal, and Spain (GIIPS), to “ensure depth and liquidity in those market segments which are dysfunctional.” These purchases reached €219.5b at the program’s peak in February 2012.
- The Outright Monetary Transactions (OMT) program was announced in September 2012, following Mario Draghi’s “whatever it takes” speech in July 2012. This addressed “redenomination risk” – the risk that some countries might be forced to leave the Eurozone area. It involved direct purchases of government bonds of a given country if this country formally applied and committed to a series of fiscal policy adjustments. While the July announcement and the OMT program have often been hailed as the “big bazooka” and the turning point in the Eurozone crisis, the program has actually has never been applied.
- The Long-Term Refinancing Operations (LTRO) was introduced in December 2011. Under the LTRO, banks received 36-month loans against a variety of collateral, under the understanding that a large share of the proceeds would be used for government bond purchases. €540b were allotted across two operations.
The Impact on Sovereign Bond Yields
The authors decompose the overall change in government bond yields into two Eurozone-wide and three country-specific components. The Eurozone-wide components were the overnight interest rate on a safe and liquid bond (representing the expected yield on a safe asset) and the term or duration risk premium. These components could be measured directly using changes in the Euro swap rate. The three country-specific components, which could only be measured directly, were:
- The default risk premium. This can be identified from changes in the yields of dollar-denominated government bonds, as these are not subject to redenomination.
- The redenomination risk premium. For Italy, this can be identified from the difference between the yields of highly rated local law corporate bonds (subject to redenomination risk) and the rate on corporate CDS (which do not cover redenomination losses for G7 countries). For Spain and Portugal, it can be identified from the difference between rate on corporate CDS (which cover redenomination losses for these countries) and the yield corporate USD bonds (which are immune to redenomination risk).
- The segmentation/illiquidity premium. The remaining residual change in yields is attributed to this component.
Since the authors treat the three components as latent variables, they apply a Kalman filter. They conduct an event-study approach, analyzing 2-day windows around the different dates of program announcement or implementation. The results were as follows:
- The SMP and OMT announcement resulted in substantial drops in bond yields across Eurozone periphery countries, while the 3-year LTROs resulted in smaller and insignificant bond yield reductions.
- On average across Italy, Spain and Portugal, reduced market segmentation accounts for 50% of the reduction in yields following the SMP and OMT, default risk for 37%, and reduced redenomination risk for 13%.
- The LTROs had little effect on any of the three country-specific components, except in Spain where they lowered the segmentation premium in sovereign bond markets.
The Effect on the Financial Sector and the Real Economy
The authors also assess the impact of the different ECB policies on the financial sector and corporate sector, by studying the a similar event study approach and using changes in stock returns and corporate bond yields.
While bank stocks increased after the SMP and OMT announcement, only a small part of this can be attributed to the higher value of government bond holdings – most is due to the effect on the economic environment. Similarly, non-financial stocks increased after the SMP and OMT announcement, but not consistently across all countries after the LTRO announcement. Corporate bond yields also decrease, especially after the OMT.
The costs and benefits of the ECB policies
The ECB interventions into the sovereign bond markets have helped, but were they worth the cost? The benefits can be measured by the increase in European stock markets and GIIPS bond markets, and the costs by the GIIPS sovereign bond value increase (assuming that this increase reflects expected future fiscal transfers). Under this calculation, the authors estimate that the benefits substantially exceeded the costs. Moreover, the net benefits are even higher when you take into account gains to the real economy beyond the stock market, such as increases in wages.