EUROPEAN Central Bank President Mario Draghi’s confirmation that the ECB is prepared to stand in the market and buy unlimited amounts of government bonds issued by Spain and other troubled European Union nations is a hugely important moment in the battle to save Europe.
He has produced a plan that can work, and if the market’s hive-mind agrees – believes, in effect that Draghi (pictured) has the firepower to keep borrowing costs down long enough for Europe’s cot-case nations to repair their crippled economies – it may not even actually need to be deployed.
Draghi’s ”outright monetary transactions” scheme centres on the ECB’s willingness to buy European sovereign bonds issued by Spain and other financially stretched European Union nations, concentrating on maturities of between one to three years.
The ECB will only buy if governments sign up for aid from Europe’s bailout funds, the European Financial Stability Facility, which has about half of its €440 billion ($A538 billion) kitty intact, and the European Stability Mechanism, a €700 billion fund that is designed to take over from the EFSF.
Bailout money has already gone to Greece, Ireland and Portugal in return for those nations’ agreement to implement tough budget cuts and debt reduction targets that are subject to quarterly reviews. Greece is persistently failing to meet its budget cuts and debt reduction targets, however, putting its bailout and its role in Europe’s recovery at risk, and Draghi says that ECB support could now be conditional on a less demanding ”precautionary” fiscal program.
Nations that missed budget targets will still risk losing their financial lifelines, but the ”precautionary” regime will be less onerous and intrusive.
There are no limits to the size of ECB’s potential bond-buying: the central bank has a bottomless cup, because it can print euros. The definition of purchasable paper has also been widened to allow for further Spanish debt downgrades, should they occur, and the ECB has no fixed bond yield target. That’s because its buying has two effects, one of which cannot yet be estimated.
The buying itself will work mechanically to push bond prices up, and through them, yields and ongoing borrowing costs for Spain and any other government targeted for assistance down.
That effect is already largely booked by the bond markets after more than a month of hints and leaks about Draghi’s proposal. Spain’s 10-year government bond yield fell by almost 0.4 percentage points yesterday after details were released, and at 6.03 per cent is about 1¼ percentage points lower than it was just over six weeks ago, before Draghi first promised to ”do what it takes” to keep the euro alive.
A larger dividend is on offer, however, if the markets decide that Draghi has headed off the prospect of troubled European countries defaulting on their bonds and leaving the European monetary system, creating loan losses for bondholders.
The interest ”risk premium” that bondholders have been demanding from Europe’s most vulnerable nation, Spain, to give them insurance against this possibility is estimated to be about 200 basis points, or 2 percentage points.
It will shrink if confidence grows that Draghi has erected a firewall that works.
The ECB says it will ”sterilise” any bond purchases, by withdrawing the same amount that it spends buying bonds somewhere else in the European financial system. Theoretically, this is a different tack to the ”quantitative easing” taken by America’s Federal Reserve and the United Kingdom’s Bank of England, which have both conducted unsterilised bond-buying operations to deliberately inject cash into the economies they are overseeing.
Sterilisation is, however, mainly aimed at placating inflation fetishists, notably Germany’s central bank, the Bundesbank, which voted against Draghi’s plan at yesterday’s ECB governing council meeting, in the belief that it breached the central bank’s ban on directly funding governments.
The reality is the ECB is also a quantitative easer: it has twice offered European banks unlimited three-year funding to keep them afloat, and has injected 1 trillion ”unsterilised” euros into the economy through that window so far.
More tangible is Draghi’s commitment that any bonds the ECB buys will rank equally with private sector holders. This heads off the prospect that private sector Spanish bondholders will sell aggressively into any ECB bond buying, to reduce their exposure to a possible repeat of the Greek debt reconstruction debacle earlier this year.
Private sector Greek bondholders were forced to accept a disproportionately heavy 53 per cent write-down in the value of their Greek bonds after the ECB declined to accept a write-down of the value of its own Greek bond portfolio – on the grounds that it would be directly financing Greece if it did.
Draghi’s playing what he hopes will be an ace. If he does need to wade into the market, Europe’s Target 2 interbank payments system will shift the ultimate creditor exposure to Europe’s stronger nations, and Germany in particular. Its claims on troubled sovereign debtors already exceed €300 billion.
Once again, however, the claims will only not be repaid if Spain or another of the cot cases defaults.
Draghi is now saying he can do what it takes to stop that happening, and that in itself may be enough to keep Spanish bond yields down. Plans to save Europe have all been about buying time for repair work to be done. It ain’t over till it’s over, but this is the best plan yet.
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