The Governing Council of the ECB has crossed another Rubicon. Backed by all Council members but one (Bundesbank’s Jens Weidman), the President of the ECB has unveiled what will be the new flagship intervention tool of the ECB, in order to ‘remove the tail risk’ (of a euro break-up), or to move from a ‘bad equilibrium’ toward a better one, to borrow from Mario Draghi’s words.
So, the ‘Outright Monetary Transaction’ (OMT – central bankers love acronyms) program will replace the defunct ‘Securities Market Program’ (SMP). Mario Draghi gave important pieces of information about this new program:
- Interventions in a given country’s sovereign market will be conditional to this country requesting financial assistance from EFSF/ESM. Practically, no intervention until a memorandum of understanding (MoU) is signed between EFSF/ESM and the country. The assistance program may be under ‘full’ conditionality (alikeGreece,IrelandorPortugal), or ‘soft’ conditionality (the so called ‘precautionary program’, or ECCL);
- Any euro area country is eligible. As far as countries under program are concerned, this holds only ‘when they will be regaining bond market access’.
- The ECB would buy government bonds with 1Y to 3Y maturities, with no ex-ante limit, and these interventions will be sterilized;
- The ECB and the Eurosystem formally accept pari passu treatment. With the benefit of hindsight, this was the main flaw of the SMP, because of the Greek PSI.
As we have explained before, the rationale of the ECB decision is to remove the convertibility premium (euro exit, in plain English) embedded in the price of some sovereign bonds, because this unjustified (in the ECB’s view) premium makes monetary policy ineffective in these markets. Concretely, the ECB wants to lower short and medium term interest rates, so that access to credit for companies and consumers would re-open.
Overall, this is good news. The new ECB President must be given high marks for the clarity of his vision –what the ECB can and cannot do, and why- and for his handling of the opposition of the Bundesbank to any government bond purchases. That only one member of the Council voted against the OMT was probably the best piece of news I heard during the press conference.
Yet, one should not expect the ECB to do miracles: on my RIS colleagues’ estimates, the ECB might target three-year bond yields of 2.5-3.5% forSpain and 2.0-3.0% forItaly and has the means to achieve these goals. For these countries, which are both in deep recessions, still significantly positive real interest rates remain a hurdle and, more importantly, credit to the private sector is not only limited by high rates, but also by the weakness of their banking sector.
Looking forward, the next two key events for the future of the euro area are due on the 12th of September. The German Constitutional Court will render its ruling on the ESM and the EU Commission will unveil its draft proposition for the banking union decided by euro area Heads of States last June. While the former is a 0/1 event, the tail risk being that the Karlsruhe Court rejects the ESM (low probability, disrupting consequences for financial markets), the latter is only the starting point of a horse trading about the scope of the transfer of sovereignty, with regards to banking supervision and resolution powers. As in all dynamic processes, the starting point matters, but it is not a predictor of the final result.
Now that the ECB has played its master card, the ball is in the camp of governments, the Spanish government to start with. Procrastinating about the request for financial assistance could be very costly, and not only for Spain.