"Every day, a new pig gets driven through the village."
By Geoffrey Smith
October 22, 2014

The European Central Bank is looking at buying corporate bonds as a way to give its latest stimulus plan more oomph, according to various media reports.

The news suggests that Frankfurt has already come to the conclusion that it needs to to more to stave off deflation, after a muted response to its much-trumpeted program of cheap new long-term loans (known as TLTROs). Economists fret that Eurozone countries such as Italy and Greece won’t be able to keep servicing their debts if the economy stagnates for any length of time.

ECB President Mario Draghi has said for a couple of months that the bank’s governing council is “unanimous” in being ready to do more if the steps he announced in September don’t revive the economy and get the inflation rate moving back towards its target of just under 2%. It fell to a five-year low of 0.3% in September.

However, corporate bond purchases would still be a step or two short of the ‘nuclear’ option of buying government debt, which would allow a much bigger injection of cash but would risk blowing up a long-simmering dispute over letting Eurozone governments off the hook for their massive debts. That argument is starting to boil up again as France and Italy defy Eurozone rules on reducing their budget deficits.

Belgian central bank governor Luc Coene told two national newspapers Wednesday that corporate bonds are a possible alternative to the asset-backed securities and so-called ‘covered bonds’ (a European cousin of ABS, mainly issued by banks to refinance mortgage loans), but that the ECB hasn’t yet looked at any “concrete proposal”.

His comments followed a story by Reuters Tuesday citing unnamed sources as saying that the ECB could start decide on the issue as early as December, and start buying in the first quarter of next year. An ECB spokesman declined to comment.

The ECB started buying parcels of bank bonds this week and will start publishing details Monday of how much money it’s pumping into the system.

The aim of the bond purchases is to drive down long-term interest rates, and to create space on banks’ balance sheets to make new loans to businesses and households. By pushing corporate bond yields down, it would also encourage companies to replace existing bank debt with bonds, creating more new lending capacity.

However, it’s far from clear how the ECB would decide whose bonds to buy. In theory, it should buy the highest-rated, i.e. safest, bonds, but that would risk distorting competition among companies, interfering in the market’s allocation of capital. Although similar criticisms have been levelled at the Federal Reserve’s policy of quantitative easing, Fed policy has been less discriminatory because it has focused on Treasury and agency debt, which acts as a benchmark for all private credit equally.

For example, Moody’s Investor Service rates Fiat Chrysler Automobiles SpA’s long-term debt B2, but Volkswagen AG’s at A3, a whopping eight notches higher. That mainly reflects VW’s much stronger balance sheet, but it also reflects, to a degree, the relative strength of the economies and banking systems in their respective home markets of Germany and Italy.

Buying VW’s bonds but not Fiat’s would only entrench the competitive advantage that VW already has from being based in Germany –the reverse of what the ECB would want to do, given the dearth of credit in Italy. By the same token, VW would argue that favoring Fiat bonds would expose the ECB to much higher risk of default and reward companies for taking on too much risk with too little capital.

Mark Ostwald, an analyst at ADM ISI in London, said the latest comments suggest how “desperate” the ECB is to come up with new ideas, citing one sour observation by a German client that “every day, a new pig is driven through the village.”

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