There was only one game in town today. After managing to calm markets with his promise to do ‘whatever it takes’ in July, this afternoon ECB President Draghi set out the latest plan to rescue the euro.
The ECB’s Governing Council has agreed (there was one dissenter – guess who) to conduct a new programme that it is calling 'Outright Monetary Transactions' (OMTs). This will involve the ECB stepping in to buy up government bonds on secondary markets, ostensibly to repair the monetary policy transmission mechanism. But there are a number of strings attached.
First, a condition for OMTs is that they will only be considered for future macroeconomic adjustment programmes or precautionary programmes (the more flexible ‘Enhanced Conditions Credit Line’), or for countries currently under such programmes as and when they (try to) regain market access. These programmes essentially impose constraints on national fiscal policy, and therefore act as a form of ‘conditionality’. If a country does not meet the fiscal targets agreed under such a programme, the ECB will stop buying its bonds.
This means that if Spain wants ECB support from OMTs, it will probably have to submit to a full programme, as a precautionary line would be of little use at this point. Italy could probably get away with an ECCL, provided Spain sorts itself out. For Ireland and Portugal, the ECB will only start to help once they come back to the market, which could well have been a spur for Ireland’s recent foray into short-term markets.
Second, the ECB will now accept the same treatment as other private creditors for bonds purchased under the OMT. One of the big problems arising from the Greek restructuring is that the ECB did not take a haircut on its holdings of bonds purchased under the old Securities Markets Programme (which is now terminated; existing bonds will be held to maturity). This meant private bondholders suffered larger losses and made investors nervous that, if another country got into trouble, they would again be subordinated by ECB purchases (they would only be paid after the ECB got all its money). The implication of subordination is that private investors facing an even larger expected loss then without ECB purchases. This was counterproductive as it drove investors away, so today’s move is good news.
Third, OMT purchases will be concentrated on the short part of the yield curve, on bonds with maturity of between one and three years. This further reinforces the conditionality imposed via the economic adjustment programmes. By only helping profligate governments out over a short term, they still have a strong incentive to put their fiscal houses in order, so that they can bring down longer-term rates and avoid having to roll shorter-term debt. In addition, any OMT holdings will mature over a relatively short period.
Fourth, there is no ex ante limit on the size of OMTs. In this, the ECB has learnt a lot from the experience of the BoE. In principle, a central bank can pump a set amount of money into the economy, as Threadneedle St has done. Or it can seek to target yields. But it cannot to both: the latter is an open-ended commitment, while the former is by definition limited. By not sewing himself into the same straightjacket as Mervyn King, Draghi has more room for manoeuvre. (He has even more from being deliberately vague about what sorts of yields will be considered as ‘too high’.)
There are a few further wrinkles. But, overall, this is an impressive attempt to help resolve the crisis while not annoying the Germans too much (although the Bundesbank President will have been the dissenter). The conditionality of OMTs will go down well with Northern Europeans, who don’t want to bail out the south. But at the same time the ECB can step in to provide potentially unlimited short-term support where it is needed, provided governments play by the rules.
That may be the biggest risk of all. Draghi knows that he is having to work with politicians, who will try to avoid pain if at all possible. If they are sensible, they will opt for support soon. One very good idea would be for Italy’s Mario Monti to get the ball rolling by asking for an ECCL. Italy doesn’t need one just yet, but it would be a clear signal that European authorities can work together to sort out this mess. More worryingly, if Spanish PM Rajoy is daft he will reject the conditionality and drive his economy even further down the plughole. Draghi has done his best; it is now up to the politicians to follow his lead.
Image by World Economic Forum [CC-BY-SA-2.0 (http://creativecommons.org/licenses/by-sa/2.0)], via Wikimedia Commons