(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. Specifically, in May 2010, the ECB announced the Securities Market Programme (SMP) whereby the ECB directly purchased government debt of distressed countries, including Italy, Spain, Portugal, Ireland and Greece and reaching 219.5bn Euros at its peak in February 2012. The stated objective of these interventions were to “ensure depth and liquidity in those market segments which are dysfunctional.” Following the “whatever it takes” speech of Mario Draghi in July 2012, the ECB introduced another programme in September 2012 to directly address the risk that some countries might be forced to leave the Eurozone area (referred to as redenomination risk). The Outright Monetary Transactions (OMT) program foresaw 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 has often been hailed as the “big bazooka” and the turning point in the Eurozone crisis, it actually has never been applied. A third program was the 3-year Long-Term Refinancing Operations (LTRO), introduced in December 2011. Under the LTRO, banks received loans with a maturity of 36 months against a variety of collateral, under the understanding that a large share of this would be used for government bond purchases. In total 540b Euros were allotted in two operations.
Assessing 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. First, the overnight interest rate on a safe and liquid bond (e.g., EIONA) serves as basis for the expected yield on a safe asset over a longer time period, while the second component reflects the term or duration risk premium. The three country-specific components are the default risk premium, the redenomination risk premium and the segmentation/illiquidity premium. The authors measure the two Eurozone-level channels by using changes in the Euro swap rate. The country-specific components can only be observed indirectly. The default risk premium can be identified from changes in the yields of dollar-denominated government bonds (as these are not subject to redenomination). The redenomination risk in the case of Italy 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). In the case of Spain and Portugal, the redenomination risk component 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 remaining residual change in yields is attributed to the segmentation component. As the authors treat the three components as latent variables, a Kalman filter is being applied. An event-study approach is used, looking at 2-day windows around the different dates of program announcement or implementation.
- 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.
- For both Italy, Spain and Portugal, the biggest contribution the yield reduction following SMP and OMT comes from the lower default risk premium and lower segmentation premium, with a smaller role for a reduced redenomination risk premium. On average across Italy, Spain and Portugal, decomposing the yield reductions due to the SMP and OMT, default risk accounts for 37% of the reduction in yields, reduced redenomination risk for 13%, and reduced market segmentation effects for 50%.The LTROs, on the other hand, 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, with a similar event study approach and using changes in stock returns and corporate bond yields. In addition, they can link the higher valuation of peripheral sovereign bonds after the ECB announcements to banks’ holdings of sovereign bonds. 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, with the larger share being explained by the expectation of a positive effect of the ECB intervention 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 was it worth the cost? Based on the increase European stock markets and GIIPS bond markets (as a measure of the benefits) and using the GIIPS sovereign bond value increase as a measure of the cost (assuming that the increase in GIIPS bond values may reflect expected future fiscal transfers) the authors estimate that the benefits substantially exceeded the costs. This does not take into account growth benefits in the real economy beyond the stock market (notably wage gains), which might be too early to assess. In summary, the contribution of the paper is both an analysis of the effects of ECB interventions during the Eurozone crisis but also developing a mechanism to assess the impact of central bank interventions on sovereign bond markets through different channels.