A large-scale bond-buying program by the European Central Bank could increase losses for investors if the eurozone had to write down public debt again, according to a lawyer who advised bondholders in the 2012 Greek debt restructuring.
Investors have been loading up on eurozone government debt this year, anticipating the ECB will buy the bonds to pump money into the stagnating economy, the process called quantitative easing (QE).
But if the ECB claims preferential creditor status for its scheme, as it did during the Greek restructuring, private investors would face greater haircuts on any future defaults because the ECB would demand to be paid in full.
“QE raises the question of treatment,” said Yannis Manuelides, a partner at the law firm Allen & Overy. “The ECB couldn’t start a massive operation without having a statement on this because every euro intervention would be seen to be aggravating the problem for everybody else.”
The assumption in markets is that the ECB, which has no preferred creditor status officially, will be on an equal footing with private investors in any bond-buying scheme. But German officials have cautioned against any move which violates a ban on the ECB funding governments and exceeds its mandate.
The ECB declined to comment, saying QE was not an official policy of the bank.
The ECB did waive seniority for a bond-purchase program, known as Outright Monetary Purchases (OMT), it announced in a bid to save the euro in 2012, when it looked as if the currency union might break up. The program did ease near-term default fears, but it was never used and faces a test in European courts next month after being challenged by German lawmakers.
The ECB’s attention has since turned to stubbornly low inflation, which is hampering the bloc’s recovery and preventing weaker countries from improving their long-term debt sustainability.
To stave off deflation, the ECB appears to be warming to the kind of QE program the US Federal Reserve and the Bank of England used in the depths of the global crisis. The Fed and BoE were spared the ECB’s headache, however, because they are permitted to finance their governments if necessary.
Allen & Overy’s Manuelides has first-hand experience of how determined the ECB can be to protect itself against losses.
Representing private investors in the Greek restructuring, he said he “complained bitterly” when the ECB argued for its preferred creditor status, on the grounds that it held the Greek bonds for public policy purposes and not to profit.
He also said the ECB’s waiver of preferential treatment in the OMT program was not as straightforward as it sounded. That program requires a country to accept a bailout with strict conditions for reform, which minimizes the risk of debt restructuring. No such conditions are likely to apply to QE.
Even so, investors expect the ECB to waive seniority for QE.
Myles Bradshaw, European strategist at the world’s biggest bond investor, PIMCO, said the justification the ECB used to protect itself against losses in Greece’s emergency debt restructuring should not apply to QE, because it would be a monetary policy tool that applied to all countries.
Jens Weidmann, the head of Germany’s Bundesbank, has also said buying assets to beat inflation was different, though he still had reservations about monetary financing.
If the ECB did claim seniority, it could stymie private sector investment in government bonds, effectively rendering its biggest policy weapon a dud.
“It opens up a Pandora’s box, and the ECB would be well advised to keep that box closed and to be pari passu with investors,” Bradshaw said.
The ECB’s former head of market operations, Francesco Papadia, said fear of investor flight would prompt the ECB to waive preferential treatment for any future bond-buying scheme.
Allen & Overy’s Manuelides agreed that the ECB could be playing with fire if it assumes seniority.
“Investors will want out. They’ll say: you want to be senior? Be senior on your own – buy everything,” he said.
But with German lawmakers on one side and investors on the other it remains unclear which path the ECB will choose.
“It’s stuck between a rock and a hard place,” Manuelides said. [Reuters]