QE revamped

Citigroup: Citigroup has a plan to unblock euro zone bond markets. Rather than buying government bonds, the US bank thinks the European Central Bank should guarantee their value. The proposal won’t solve Europe’s debt problem. But, it looks a cleaner way for the central bank to prop up markets.

The ECB is aiming to restore market confidence by acting as a backstop buyer of sovereign debt. The intervention has had some early success. Bond prices have stopped falling. But the ECB risks stoking inflation by pumping money into the economy, so it has to sterilise its purchases by sucking out the cash. At the moment, it does so by attracting deposits from banks.

Second, the more bonds the ECB buys, the more it will have to sell back to the market in the future. That could make investors wary of buying government bonds in the future, dragging out the crisis. Citigroup’s plan is designed to achieve the same result as the ECB’s bond-buying program, but avoid some of its flaws. The US bank thinks the central bank should use some of the funds it has earmarked to offer insurance against sovereign default. Instead of selling government bonds to the ECB, investors would pay an upfront premium, followed by fixed annual payments. If the country defaults, the ECB would accept the bonds at par.

Banks can already insure against sovereign default by buying credit default swaps.

For Greece, this currently costs about six percentage points of the debt being insured upfront, and a further five per cent every year. Under Citigroup’s plan, however, the ECB insurance would be subsidised. This approach would mimic the ECB’s bond-purchasing programme. It would give investors more confidence in government debt, and allow banks to reduce their risks. But unlike the current plan, the ECB would not be pumping so much money into the economy.

There would also be less risk of an overhang in the market. Of course, as with bond purchases, the ECB would still be assuming sovereign credit risk. There is a danger it could end up as a government-funded AIG, liable for heavy losses if Greece or other euro zone countries default. The ECB’s main aim is to buy governments some time to solve their problems. Guarantees may be a more elegant way of achieving this than buying bonds. But for markets to start working properly, the risk of sovereign default needs to be addressed.