Yesterday, 06 of
September 2012, Mario Draghi the Italian President of the European Central Bank
(ECB) announced the new measures that the central bank will adopt in order to
prevent the collapse of the Eurozone. The markets immediately reacted to the
news with euphoria. The best performer was IBEX 35 (Madrid) with a 4,9% gain,
followed by FTSE MIB (Milan) 4,3%, CAC 40 (Paris) 3,06%, DAX (Frankfurt) 2,41%
and FTSE (London) 2,11%. Is this euphoria justified?
First, lets see
what exactly Mario Draghi said and which will be the measures that the ECB will
adopt from now on. Lets begin with the first press release, in which the ECB
comments the new measure called Outright Monetary Transactions (OMT):
The OMT allows the
ECB to buy sovereign bonds of European countries in the secondary market.
Therefore, if a country finds itself in a difficult situation, the ECB can
intervene in the secondary market in order to lower the interest rates of its
sovereign debt. Why is this important? The interest rate at which the sovereign
debt is exchanged in the secondary market determines, or influences, the
interest rate that is paid in the primary market. To put it simple, when a
state spends more than what it earns it has a deficit that has to be filled by borrowing
money. When a state borrows money it goes to the primary market and asks for
the money. Investors, depending on their perception of the probability that the
state will payback the borrowed money, will ask for a higher or lower interest
rate. After the money is borrowed, the debt is exchanged in the secondary
market depending on the perceptions that investors have about the state ability
to payback the borrowed amount. Therefore, there is a strict connection between
primary and secondary markets. But lest go back to the OMT. This mechanism
allows the ECB to buy sovereign debt on
the secondary market with “no ex ante
quantitative limits”, that is it can buy whatever quantity it considers
necessary. This part was the part that caused the euphoria in the markets.
However it is better to read all the press release in order to understand the
conditions attached to this purchases. Draghi in his speech insisted a lot on
this conditionality and the first part of the press release is called
Conditionality:
“A necessary condition for Outright Monetary
Transactions is strict and effective conditionality attached to an appropriate
European Financial Stability Facility/European Stability Mechanism (EFSF/ESM)
programme. Such programmes can take the form of a full EFSF/ESM macroeconomic
adjustment programme or a precautionary programme (Enhanced Conditions Credit
Line), provided that they include the possibility of EFSF/ESM primary
market purchases. The involvement of the IMF shall also be sought for the
design of the country-specific conditionality and the monitoring of such a
programme.”
This means that
the ECB will buy sovereign debt only on the condition that the country already
applied to the EFSF/ESM program or to the Enhanced Conditions Credit Line (a
precautionary program). This is very important because it means that before any
intervention of the ECB, given that the state already applied to one of these
programs, the receiver of the help will be intervened by the troika and will be
asked to comply with strict conditions like it happened with Greece. At the
moment, therefore, nor Italy nor Spain would be eligible for the OMT. Only if
they first apply to the EFSF/ESM or ECCL, asking for these mechanisms to buy
their debt in the primary market in exchange for structural reforms, the ECB
can go on and buy their bonds in the secondary market in order to decrease
their interest rates. Moreover the ECB specifies that it can stop buying bonds
of any country if the country is not complaining with the agreed terms and is
not doing the necessary structural reforms. This thing is important because
Rajoy and Monti are doing everything they can in order to not apply to these
programs and be intervened by the troika, losing their sovereignty and losing
popularity among their voters.
In the second part
of the release, the ECB states that “transactions
will be focused on the shorter part of the yield curve, and in particular on
sovereign bonds with a maturity of between one and three years”. Buying
only short term bonds (between one and three years) is a signal that the ECB
still has fear of inflation in the longer term so it buys bonds that mature in
maximum three years and at maturity the liquidity poured into the market will
be absorbed again in an effort to avoid a future increase in inflation.
In the third part
(Creditor Treatment) the ECB makes a statement that could be really
controversial and could create problems between the ECB and the Bundesbank:
“The Eurosystem intends to clarify in the
legal act concerning Outright Monetary Transactions that it accepts the same
(pari passu) treatment as private or other creditors with respect to bonds
issued by euro area countries and purchased by the Eurosystem through Outright
Monetary Transactions, in accordance with the terms of such bonds.”
This is crucial.
It means that if there is any loss, that is some country cannot payback its
debts, the ECB will face losses exactly as other private creditors. When Greece
defaulted and restructured its debt, the ECB did not accept to face losses on
its holdings and this increased the losses faced by other private creditors. A
simple example: if a country owes 100 in debt, 50 to private creditors and 50
to the ECB, and it can payback only 60, if the ECB is considered pari passu
everyone faces a haircut of 40, that is the ECB will write down 20 and recognize
30 in its balance sheet and the same will do the private creditors. However, if
the ECB states that it has priority and will not face losses, only private
creditors will have a write down of 40 and a balance sheet value of 10, instead
of 30. The fact that the ECB ranks pari passu is important because private
investors are not considered junior creditors, will be safer and will ask lower
interest rates. However, we have to remember that the equity base of the ECB is
really small and in case of a default of between 50 and 80 billions, its equity
will be wiped out. If this happens, the recapitalization of the ECB will be
over the shoulders of the other states that are not defaulting and especially
over the shoulders of the majority “shareholders”, that is Germany and its
taxpayers. Therefore, the decision to rank pari passu will be not easily accepted
by German taxpayers.
In another point
the ECB states that the liquidity created by the OMT program will be “fully sterilized”. That is, the ECB
will reabsorb the liquidity selling other assets or increasing the amount of
money that private banks deposit at the ECB. I think that the sterilization
will be a problem and will be not that easy to put in practice. If the
sterilization will be done through the selling of other assets, it will be
difficult to do because it will sink the value of those assets. In this case the
ECB will incur losses and there is the risk of sinking the market of these
assets (other sovereign debt, MBS etc.). If the ECB sterilizes attracting
deposits from banks it will have to do it increasing the interest rates on
these accounts and therefore incurring in losses. However, the most problematic
aspect is that if interest rates will go up in the future as the economy exits
the crisis, banks will withdraw the money and put it in more profitable projects,
increasing the liquidity in circulation and the probability of an increase in
inflation (difficult to sterilize).
The good news is
that the ECB will be more transparent than before and will publish weekly the
market value of the OMT transactions and monthly the breakdown of these
transactions by country. That is, we will know how much the ECB purchased in
the secondary market (weekly) and which bonds it purchased (monthly).
In another press
release, “Measures to preserve collateral availability”, the ECB “decided to suspend the application of the
minimum credit rating threshold in the collateral eligibility requirements for
the purposes of the Eurosystem’s credit operations in the case of marketable
debt instruments issued or guaranteed by the central government, and credit
claims granted to or guaranteed by the central government, of countries that
are eligible for Outright Monetary Transactions or are under an EU-IMF
programme and comply with the attached conditionality as assessed by the
Governing Council”. This statement recognizes that banks in the peripheral
countries are really thirsty and in deep need of liquidity. Due to the
connection between governments and their financial institutions European banks
have filled their balance sheet with their government bonds, replacing the
absent foreign demand. For example, Italian banks are filled with Italian
sovereign bonds, Spanish banks with Spanish sovereign bonds and Greek banks
with Greek sovereign bonds. Therefore, now banks are filled with sovereign debt
that has been downgraded by rating agencies and this debt till now was not
eligible to be posted as a collateral in order to obtain the much needed
liquidity. The ECB now is stating that it will accept sovereign bonds of states
that are eligible for the OMT program or under EU or IMF intervention. In this
way Greek banks that need liquidity can go to the ECB and ask some liquidity
posting as a collateral Greek sovereign bonds, even if these bond have credit
ratings below the investment grade.
Conclusion
Markets reacted as
the ECB announcement was good news but actually it is not. The ECB recognized
the gravity of the European situation and decided to adopt extreme measures in
order to prevent the collapse of the Eurozone. However, these measures can be
very dangerous for the ECB and for European future stability, especially if
mechanisms of sterilization will not work given that the collateral posted will
be of worse quality and difficult to resell in order to absorb the desired
amount of liquidity. Moreover, the Bundesbank has yet not agreed on this
extreme measures and they have still to be approved by Germany. Therefore, at
the moment, these measures are only theoretical and it is possible that Germany
will refuse to support this measure at the moment of truth, when the ECB will
be willing to buy unlimited amounts of sovereign bonds putting in danger German
taxpayers money and risking an increase in inflation, fact that is not seen
under a positive light by the Germans. The risk of inflation is not present at
the moment because the destruction of credit is faster than the money creation
by the ECB, banks are undercapitalized and have not creditworthy borrowers.
However the difficult sterilization of the increased money supply could pose an
inflatin problem in the future.
The positive
reaction of the market is not sustainable and the problems in the Eurozone are
far from over.
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