Selective Bond Purchases – May the ECB Chose Winners and Losers?

1 Introduction

Since 2009, the European Central Bank (ECB) has announced and launched several asset purchase programmes with different objectives and modalities. In the Asset Purchase Programme (APP), which was adopted in 2015 and includes the purchase of government and corporate bonds, the announced objective is to create the monetary accommodation necessary to ensure medium-term price stability by pushing down interest rates not only at the short end, but also at the medium and long ends of the yield curve. In this case, one can also speak of a classical quantitative easing (QE) programme.

However, in addition to the APP, a second category of asset purchase programmes announced by the ECB aims to stabilize selective markets and to counteract specific market segmentation and illiquidity problems, thereby ensuring monetary policy transmission. These include the Securities Market Programme (SMP) and Outright Monetary Transaction (OMT), announced during the sovereign debt crisis, as well as the Pandemic Emergency Purchase Programme (PEPP), announced during the COVID-19 pandemic.

In this second category of purchase programs, aimed at stabilizing individual markets, the ECB did not always adhere to the principle of market neutrality. Market neutrality means that, where possible, a central bank tries to keep the relative prices of all assets equal so as to not give individual Member States or selected corporate sectors a financial advantage and to not hamper competitiveness and market discipline.

In recent months, a lively economic debate about the ECB’s principle of market neutrality has flared up anew. This was triggered, among other things, by two decisions of the Governing Council to deviate from the principle of market neutrality in further purchase programs by designing them in such a way that only market participants of a certain segment could participate or be eligible for purchases. These are the ECB’s recently announced Transmission Protection Instrument (TPI) and the now selective purchases of corporate bonds in its Corporate Sector Purchase Programme (CSPP), with which the ECB aims to decarbonize its corporate bond holdings, thus contributing to the fight against climate change.

Without doubt, the stability and preservation of the European Economic and Monetary Union as well as the reduction of climate risks are important socio-political and economic tasks. However, the question arises whether the ECB, as guardian of monetary and price stability, should and may intervene for these important goals. This study discusses whether such drastic interventions by the ECB in market activity are justified from economic and legal perspectives. The aim is to provide a basis for further discussions on the ECB’s competences.

2 Selective Purchases of Government Bonds to Support Uniform Monetary Policy Transmission

With euro area inflation rising steadily since mid-2021, the ECB started to announce a normalization of its monetary policy at the end of 2021. When inflation accelerated further after the Russian invasion of Ukraine in February 2022, the ECB’s first reaction was to stop net purchases under the Pandemic Emergency Purchase Programme (PEPP) at the end of March 2022 and under the Conventional Asset Purchase Programme (APP) in June 2022. In addition, policy rates were sharply increased by a total of 3.5 percentage points between July 2022 and April 2023, the largest rate hike since the creation of the monetary union. Starting in March 2023, bond holdings under the APP are being reduced by an initial €15 billion per month until the end of June. In response to the progressive monetary policy normalization, the yield premiums for government bonds of the peripheral countries started to rise steadily from the beginning of 2022. Highly indebted countries, such as Italy, Greece, Portugal and Spain, are facing a stronger increase in their bond yields than the “core countries” of Germany and France.

In reaction to these sovereign bond spreads, the ECB announced a new instrument on July 21, 2022, the Transmission Protection Instrument (TPI), to “ensure that the monetary policy stance is transmitted smoothly across all euro area countries” as the ECB continues policy normalization. The ECB explains that the TPI will be a new addition to the toolkit and “can be activated to counter unwarranted, disorderly market dynamics that pose a serious threat to the transmission of monetary policy across the euro area.” The TPI allows for secondary market purchases of securities “issued in jurisdictions experiencing a deterioration in financing conditions not warranted by country-specific fundamentals.”

Effective transmission of monetary policy impulses is no doubt a necessary prerequisite in the pursuit of a price stability-oriented monetary policy.^[1] Nevertheless, the ECB has to explain the relation between the transmission mechanism as an “interim” goal with price stability as its primary and “end” goal. Currently, with surging inflation, the ECB is trying to curb it by increasing interest rates. If TPI was activated, the ECB is under an increased burden of justification to explain how further asset purchases fit into the overall monetary policy stance of fighting inflation.

In addition, the ECB must prove that the distortions of the transmission mechanism pertain to the monetary policy domain in accordance with Art. 127 TFEU. It is only if market failures are identified as the cause of the financial fragmentation with regard to sovereign bond yield spreads, that the ECB should take selective and targeted measures to address these causes. Otherwise, monetary policy would amount to a means to support the debt of some Member State/s experiencing high risk premia as consequence of said Member State’s fiscal and economic policy. Fiscal support for highly indebted Member States that struggle with increased, but justified, risk premia is a decision to taken by Member States according to the democratic processes in place. Such a decision should be subject to political and public scrutiny.

Thus, a preferential treatment of some Member States by selective bond purchases, as it is potentially the case if TPI is activated, must be justified on the grounds that such purchases fall within the competence of the ECB, i.e. it should rest on monetary considerations in line with the overall mandate of the ECB. Not only did the ECJ stress this point in its Gauweiler Decision, but the Governing Council also included this requirement in its Press Release by stipulating that the deterioration in financing conditions, potentially hampering monetary policy transmission, may “not [be] not warranted by country-specific fundamentals.” The decisive question then becomes: How will the ECB define what spreads are appropriate versus unacceptable? How will the ECB assess, with regard to what criteria, whether yield spreads are warranted by country-specific macroeconomic fundamentals?

The list of determinants of bond yields discussed in the literature is long. Furthermore, expectations about the future solvency of bond issuers play a decisive role in their development.^[2] Thus, assessing whether the level of bond yields is justified requires not only the consideration of all potential fundamental factors, but also an objective forecast of future economic and financial conditions. Due to this complexity, the assessment of whether current bond yield spreads are unwarranted will always involve a high degree of discretion.^[3] While this gives the ECB wide latitude in the decision to activate TPI, conversely it will inevitably face mistrust and pressure to justify itself to critics.

In view of these concerns, the Member States would be well advised to consider other institutional setups and measures that are better suited to address the challenges of risk fragmentation and rising yield spreads. It is primarily the responsibility of governments to take measures, either unilaterally or at the EU level, within the existing European institutional and legal framework to combat rising public debt and its economic consequences.

3 Selective Corporate Sector Bond Purchases to Decarbonize the CSPP

In July 2022, the ECB declared its commitment to join in the fight against climate change, which the European Commission launched prominently with its “Green Deal.” In this vein, the ECB announced plans to decarbonize its corporate bond holdings in line with allocating bond purchases according to the principle of market efficiency.

Before this, the ECB’s bond purchases under the CSPP adhered to the principle of market neutrality; i.e. bond purchases in proportion to the market value of eligible bonds in order to replicate existing market structures. However, such a market neutral allocation of purchases resulted into an emission bias of the CSPP holdings, as e.g. Matikainen, Campiglio, and Zenghelis (2017) and Schoenmaker (2021) show. Papoutsi, Piazzesi, and Schneider (2022) use data on the ECB’s bond holdings, alongside data on issues, to confirm that the ECB’s bond portfolio tends toward brown rather than green sectors compared to the market portfolio. They state that this is a direct consequence of the structure of the bond market and the simple market neutrality formula that the ECB has applied so far.

Thus, by adhering to the principle of market neutrality, the ECB perpetuated and exacerbated these market failures and, consequently, the ECB portfolio mirrors the overrepresentation of emission intensive sectors. Thus, in order to correct these market inefficiencies, the ECB is gradually decarbonizing its corporate bond holdings by way of so-called tilting measures that favor issuers with better climate performance. Tilting means that the share of assets on the Eurosystem’s balance sheet issued by companies with a better climate performance will be increased compared to that by companies with a poorer climate performance.^[4] Thereby, the ECB aims to mitigate climate-related financial risks on the Eurosystem balance sheet and to incentivize issuers to improve their disclosures and reduce their carbon emissions in the future. The ECB started to apply tilting measures as of October 2022 within corporate bond purchases.^[5]

As justification, the ECB puts forth two reasons: (i) the mitigation of climate-related financial risks on the Eurosystem balance sheet; and (ii) the fight against carbon emissions and the objective to contribute to a CO2-neutral, sustainable economy. Counteracting financial risks for the Eurosystem balance sheet is a legitimate objective and justification for discriminatory measures, as it relates to the ECB’s contributory mandate to support the stability of the financial system (Art. 127 (5) TFEU) and the ECB’s financial independence (Art. 282 (3) TFEU).

Sustainability objectives are enshrined in the Treaties in Articles 3 (3) TEU and 11 TFEU. They are also integrated in the ECB’s mandate by reference to Article 3 TEU in the ECB’s secondary objective in Article 127 (1) 2 TFEU. Therefore, the ECB can make recourse to its task to support the economy with a view to sustainability objectives monetary policy as a justification to discriminate against bonds from carbon intensive sectors. However, is this justification also in line with the overall mandate of the ECB? Can the ECB choose to support certain environmental, social, economic and other non-monetary policy objectives contained in the EU’s agenda in Article 3 TEU via its contributory function to support the economic policies in Article 127 (1) 2 TFEU?

This question is linked to delineating how far the ECB’s mandate supports discriminatory measures, especially in light of its secondary objectives. While the ECB has an exclusive competence with regard to price stability, it has only contributory competence in the area of economic policy. This nuanced competence structure is also warranted by democratic considerations, since it is not the ECB’s task to conduct economic policy and to decide and choose among the many potential economic policy objectives. The ECB’s independence is functionally tied to its task of maintaining price stability and is also limited in this respect. The ECB is neither equipped to take distributional decisions beyond monetary policy nor able to decide which economic policy objective – be it the fight against unemployment, the fight against climate change, or the support of families – should be prioritized over others.^[6]

The recourse to the concept of market efficiency alone is vague and, thus, difficult to operationalize. From a microeconomic point of view, it can be an efficient allocation of resources to invest money in polluting industries as long as the returns remain high, especially since the costs of climate change are not borne proportionally by those firms that are mainly responsible for the emissions. From a medium- and long-term macroeconomic perspective, in contrast, it is not efficient to invest financial resources in polluting and carbon intensive sectors. However, it is not up to the ECB to decide on the benchmark for market efficiency with regard to non-monetary policy objectives. Rather, it is for democratically elected governments to decide what constitutes an efficient allocation of resources with regard to societal preferences.^[7]

The fact that the EU Commission and the Member States have expressed their normative preferences with the Green Deal initiative and the implementation of EU standards, such as the Taxonomy Regulation or the forthcoming EU Green Bond Standard, does also not suffice to compensate the missing democratic legitimacy of the ECB to take such decisions.

4 Conclusions

There is no doubt that the ECB is currently facing major challenges. It has to make a single monetary policy for 20 rather heterogeneous Member States with sovereign economic and fiscal policies. At the same time, climate-related financial risks need to be addressed. In recent years, the ECB is meeting these challenges by making selective bond purchases and deviating from the principle of market neutrality.

While these challenges are pressing and undoubtedly valid policy goals, it must be kept in mind that the ECB only has exclusive competence in monetary policy, as opposed to its contributory role to “support of the general economic policies in the Union,” which remain decentralized at the level of the Member States (albeit subject to coordination and certain harmonization of rules). It is not up to the ECB to compensate for the lack of fiscal integration with monetary policy to ensure that the euro area is not torn apart by the diverging economic and fiscal situations of its Member States, as are reflected in the financial markets.

There are many initiatives on the EU level with regard to a variety of policy objectives that the ECB could potentially adhere to and support with its monetary policy measures. Right now, the fight against climate change is the most important of all, but this can change. The Ukraine crisis shows that political preferences with regard to fossil energy can change quickly. How should the ECB behave then? Or, what if – in a hypothetical scenario – in the years ahead, the EU Commission decides to make the fight against child poverty its highest priority and decides to deprioritize sustainability goals? Does the ECB also have to change accordingly? These questions show that the ECB cannot compensate for its limited democratic legitimacy to make distributional decisions by adhering to the democratic legitimacy of other bodies. Choosing winners and losers, discriminating on the grounds of social, economic, environmental, or other grounds is beyond the ECB’s competence and outside of the ECB’s democratic foundation.