Press Releases

6 September 2012

Below we outline the key points of today’s ECB decision to launch unlimited, but sterilised, purchases of government bonds, and provide our take.

Summary: The ECB’s decision to buy ‘unlimited’ amounts of short-term government debt is likely to prompt a positive market reaction. However, on the downside, it transfers far more risks from struggling banks and governments onto the ECB’s balance sheet, without providing any fundamental solution to the crisis. It will also be virtually impossible for the ECB to impose effective conditionality on debtor countries, meaning that the ECB can only hope that a series of unpredictable political decisions in member states will go in its favour. If not, this action could actually prove to be a disincentive for Spain, Italy and others to reform, making the crisis worse in the long-term.

Purchase of short term debt (under three years) from struggling economies

What does it involve? The logic here is that buying short term maturities is less risky but will still pull down yields across the board. The hope is also that it frees up cash in peripheral banks to lend more or purchase more domestic sovereign debt (reducing borrowing costs).

Open Europe take:

• The short term yields are for the most part not the problem. There is already strong demand for a lot of short term debt - even France has been able to issue at negative rates. These low rates, along with the 0% deposit rate, are distorting money markets which could actually have negative impact on funding for banks and struggling economies.

• A large amount of short term sovereign debt is posted as collateral for borrowing from the ECB – banks cannot or will not want to sell this. Buying up this debt could exacerbate the shortage of quality assets to post as collateral at the ECB for struggling banks.

• As with the Long Term Refinancing Operation (LTRO) the money may not flow into riskier assets (longer term peripheral debt) but be hoarded and used to ease bank funding pressures.

• Spanish and Italian banks may use funds to buy up more domestic sovereign debt, further intensifying the sovereign banking loop (something both the ECB and the Commission want to break) and increasing nationalisation of the financial markets in the eurozone.

• This may encourage countries to issue more short term debt, making them more susceptible to changes in borrowing costs and more reliant on the ECB. When asked on how the ECB would deal with this Draghi had no good answer.

Conditionality

What does it involve? Linking ECB purchases to requests from the Eurozone’s bailout funds, the EFSF/ESM, in order to provide some conditionality and ensure that ECB cash does not replace reforms.  

Open Europe take:

• With respect to countering moral hazard, this is far from enough. Previous bailout programmes have shown the eurozone is hesitant to revoke funding even when conditions are breached.

• Absent becoming a fully-fledged political body (which would most certainly violate its mandate), the ECB will find it virtually impossible to effectively enforce conditionality. The only option it has is to withdraw funding, however, this will be impossible to do without causing huge market distortions as states become reliant on this cash flow. Crucially, there’s still no exit strategy for countries to get off ECB funding.

• There is clearly a time lag between the assessment of conditionality (often done on a quarterly basis) and the on-going purchase of government bonds.

Unlimited but sterilised purchases  

What does it involve? The ECB will take in liquidity from the market equal to the amount it injects with its bond buying. This was done under the Securities Markets Programme by issuing deposit certificates, where funds are posted at the ECB for up to week. 

Open Europe take:

• Sterilisation is ultimately a matter of semantics when a central bank commits to “unlimited” liquidity provision and bond purchases. This is especially true since ECB deposit certificates can still be used as collateral for borrowing from ECB – meaning the liquidity the ECB removes with deposits can simply be recycled through its own liquidity provision.

• Draghi gave no indication on the rates or maturity of the sterilisation process – this will dictate how attractive and successful the sterilisation will be. If rates are too low then sterilisation may fail, if they are too high banks could be encouraged to hoard cash at the ECB, limiting the effectiveness of the programme.

 Seniority of debt purchases

What does it involve? Under the SMP ECB purchases of debt were proven to ‘senior’ to the debt held in the private sector, meaning the ECB did not take losses under a restructuring (thereby increasing the potential loss for investors). Under the OMT Draghi state purchases would be senior  

Open Europe take:

• This may be the case, de jure, however de facto, the ECB will likely be senior under a restructuring, as was shown in the Greek restructuring. In that case there was no legal precedence making the ECB senior, simply the desire to avoid complicated losses. After all, if the ECB took losses on OMT loans, it would clearly constitute direct financing of governments, which is explicitly illegal under the ECB’s mandate.

Widening of collateral rules  

What does it involve? Essentially the decision suspended the minimum credit rating requirement for government or government guaranteed bonds from bailed out countries used as collateral at the ECB.

Open Europe take: 

• This may ease the problem of lack of collateral in struggling countries, but will also transfer far more risk onto the ECB’s balance sheet, particularly in the form of junk bonds guaranteed by financially unstable governments such as Greece, Spain and Italy (once they have entered bailout programmes).

• Could result in banks issuing debt, getting a guarantee from the government and then using it to gain funding from the ECB. This becomes incredibly circular and borders on allowing banks to create their own financing.

Two more questions are worth considering: 

Does this restore the broken transmission mechanism?
Draghi has consistently highlighted the breakdown of the transmission of monetary policy to the real economy – meaning that businesses in particular have nowhere to get credit – as a significant problem in the crisis. High sovereign borrowing costs have exacerbated this by distorting rates for domestic banks and corporations, and the interbank market has effectively collapsed.

The reason sovereign rates have had such a big impact in impairing the transmission mechanism is because the sovereign-bank-loop – domestic banks and governments depending on each other – is so tightly engrained. Today’s ECB decision threatens to make it worse, if it succeeds in encouraging banks to load up on domestic sovereign debt. The LTRO should have helped restore the interbank market but the channels were shown to be very hard to reopen once closed. This policy may come up against a similar problem, especially if the broader confidence remains subdued.

Furthermore, in some cases (e.g. Spain) the breakdown of the transmission mechanism is also a result of a massively undercapitalised banking sector, which today’s decision won’t fix.

Does this tackle the ‘convertibility risk’ or fear of a euro break-up?
The stated aim of this programme is to show the irreversibility of the euro. In the short term the move may help quell fears that divergent borrowing costs could drive a eurozone break up. However, borrowing costs are mostly a symptom of the underlying differences and problems - not a cause (although they are reinforcing problems). Unless these issues (mismatched competitiveness, undercapitalised banks, lack of growth prospects and political uncertainty) are tackled then masking the gap in borrowing costs can only, at best, buy time. At worst, it could serve as a disincentive for reform and prove extremely difficult to wind down without creating an even graver crisis than the one that the original intervention was meant to stave off.

NOTES FOR EDITORS

1) For more information, please contact the office on 0044 (0)207 197 2333 or the author Raoul Ruparel on 0044 (0)757 696 5823.

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