Greg Ip

Articles by The Economist’s U.S. Economics Editor

The ECB’s new bond purchase programme: Not too little, possibly too late

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Sep 6th 2012, 15:23 by G.I. | WASHINGTON

[Greg Ip]

SINCE the euro crisis erupted, the European Central Bank has been torn between its legal and philosophical aversion to financing governments and its duty as lender of last resort. Today, it appears to have reconciled the two, erring on the side of the latter.

At the end of its governing council meeting today, the ECB announced the much-anticipated details of how it would resume intervening in the region’s government bond markets. Using its newly christened Outright Monetary Transactions (OMT), it will buy sovereign bonds of one- to three-year maturity, provided the issuing country has agreed to a fiscal adjustment programme with either the European Financial Stability Facility, or its successor, the European Stability Mechanism.

Mario Draghi, the ECB president justified the programme as a necessary adjunct to monetary policy, because the ECB’s ability to set interest rates for the euro zone as a whole has broken down over fears that some countries may leave the single currency. He never used the words “lender of last resort”, a role the ECB readily accepts for banks but not for governments. Nonetheless, that is the de facto purpose. The purchases will act as “an effective back stop to remove tail risks from the euro area,” Mr Draghi told reporters. “Bond markets are distorted … in all directions.” The new purchases will restore “monetary policy transmission and recreate the singleness of the monetary area.”

The broad outlines were as expected, and the underlying details were reassuring.

First, the ECB laid out two ways countries’ bonds would qualify for ECB buying: if the country enters a full macroeconomic adjustment programme, as Portugal, Greece and Ireland have; or a less stringent “precautionary programme,” essentially a line of credit to countries with sound policies experiencing temporary shocks. This is important: the latter offers Spain and Italy a less treacherous way to access the ECB’s balance sheet. As Mohamed El-Erian of Pimco has observed, entry into a full adjustment programme signals the end of access to private capital markets. That creates an enormous incentive to wait until it’s almost too late.

Second, the ECB made clear OMT purchases were, theoretically, unlimited, ie they have no “ex ante quantitative limits”. Mr Draghi said they would end when the goals are achieved or the recipient countries stop complying with their conditions.

The ECB had always insisted purchases under its previous Securities Market Programme, (SMP) were temporary. The effect on yields was thus fleeting; investors could not be sure that Europe could or would commit the money necessary to meet the potentially enormous financing needs of every country at risk. Since the ECB can simply print the money it uses to buy bonds, its resources are theoretically unlimited. (It will “sterilize” the impact of its bond purchases on the money supply, but that should pose no constraint on how much it buys.)

Third, the ECB will not insist on senior credit status; it will rank “pari passu” with other holders of the same bonds, meaning in the event of a default it will not insist on being paid in full ahead of others. Without that proviso, official intervention threatened to accelerate the flight of private capital. Mr Draghi noted, however, that this did not apply to the bonds previously purchased under the SMP.

The one major omission was detailed criteria under which the ECB would intervene. There will be no explicit cap on yields or spreads. Mr Draghi said the ECB will examine a variety of indicators, including yield levels, yield spreads, credit default swaps, liquidity conditions, and volatility.

This is good enough, for now. Yields on Spain’s 10-year government bonds dropped to 6.09% from 6.41% on Wednesday; on Italy’s, to 5.36% from 5.51%. Stockmarkets rallied. Neither Italy nor Spain have yet said they would seek aid, preferring to await the details of the ECB’s programme. Barclays said it expects Spain to sign a memorandum of understanding with the European finance ministers in early October, while Ireland could actually qualify even sooner, assuming it regains access to the bond market.

I suspect, however, that in coming weeks, the limitations of what the ECB has done will set in. Mr Draghi has probably succeeded in taking a full blown crisis in Italy or Spain off the table, but not in restoring financial conditions that will get the region growing briskly again.

Today Eurostat said GDP in the euro area fell 0.2% in the second quarter from the first, and 0.5% from a year earlier, confirming the region is in recession. Weak purchasing managers’ indices for August suggest the recession has persisted into the third quarter. Today, the ECB sharply downgraded its growth projection for the region, to between -0.6% and -0.2% for 2012 and between -0.4% and 1.4% for 2013.

This is due in great part to the credit crunch now enveloping so many countries. ECB data published on September 3rd showed a sharp rise in borrowing rates for companies and households in Italy and Spain, and a sharp drop in Germany, where, Barclays notes, rates on home loans are now at a record low. This is not just due to banks’ higher borrowing costs, but because of an outflow of deposits which is squeezing lending capacity; loan volumes are contracting. In Spain, private capital equal to a staggering 50% of GDP flowed out in the second quarter, according to Nomura.

Some, but not all, of this will be ameliorated by the ECB’s actions. JP Morgan reckons two-year yields would be 2% in Italy instead of 2.9% without convertibility risk, and 1.7% in Spain instead of 3.7%. It is almost certainly too optimistic to expect all of that premium to evaporate. Mr Draghi said only some of the widening in spreads was due to convertibility risk; some, he said, was due, fundamentally, to the weak state of those countries’ finances. Those countries will have to stick closely to the path of austerity, and until they are finished, they can expect tougher borrowing conditions than northern Europe.

Despite Mr Draghi’s efforts to portray the purchases as purely within the ECB’s monetary responsibilities, there is no denying that they wander far from the ECB’s original mandate. That’s why the vote was not unanimous. Mr Draghi did not name the lone dissenter, but it was almost certainly Jens Weidmann, president of Germany’s Bundesbank. Though still passionately opposed to the ECB’s bond purchases, Mr Weidmann seems to have made up his mind that he can achieve more as a vocal dissenter inside the ECB than by resigning, as his predecessor Axel Weber did.

If only to avoid making Germany and Mr Weidmann even more unhappy, the ECB will not aim to give peripheral countries the same borrowing rates as the northerners. As a result, its actions as lender of last resort will not miraculously restore the potency of its monetary policy. As the experience in both America and Britain shows, even a central bank that has interpreted its lender of last resort role quite broadly and implemented ultra-easy monetary policy can only do so much to counteract the vice of deleveraging, austerity and external weakness. This will be even more so in Europe where the ECB shows no interest in unorthodox monetary policy.

The ECB seems to have acted in time to save the euro. Whether it has acted in time to save the euro economy remains to be seen.

The original article is linked here.


Written by gregip

September 6, 2012 at 12:55 pm

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