Why The ECB's OMT Will Not Lead To European "Stabeeleetee"

You could be forgiven for believing that the ECB's talk and plans have indeed solved the European problems. The market's reaction appears to confirm all anchoring bias and thanks to overly bearish positioning has sent all but the long-term-est bears scurrying for their rabbit-holes - as once again 'tail-risk has been removed' - just like LTRO, the SGP, and The Grand Plan before it. However, as BofAML notes in this must read note, we do not believe the ECB move will necessarily lead to a permanent stable equilibrium for the euro area for two reasons: 1) a stable equilibrium would require certainty about the ability of countries to restore debt sustainability, i.e. that they will respect an agenda of economic policy reforms and/or; 2) certainty about the ECB course of action, i.e. that the ECB will purchase bonds in such a way that we will not observe renewed financial market stress as we did this summer. Such certainty would require both Spain and Italy to put their faith in the Troika’s hands and the ECB to pre-commit in return, which seems to us very unlikey at this time.

Via BofAML: The ECB OMT: End game or (some) more trouble?

The ECB backstop might not remove all uncertainty…

At its meeting on 6 September, the ECB announced a programme of support for euro area countries struggling under too-high yields. The bank will make unlimited purchases of debt if rates soar beyond the level warranted by a country’s public finances and economic situation to address Euro breakup risks. Following last week’s press conference, Spanish and Italian bond yields fell sharply. The subsequent question should be whether this will lead to a more stable equilibrium for the euro area.

We do not believe the ECB move will necessarily lead to a permanent stable equilibrium for the euro area for two reasons:

a stable equilibrium would require certainty about the ability of countries to restore debt sustainability, i.e. that they will respect an agenda of economic policy reforms and/or;
certainty about the ECB course of action, i.e. that the ECB will purchase bonds in such a way that we will not observe renewed financial market stress as we did this summer.

Such certainty would require both Spain and Italy to put their faith in the Troika’s hands and the ECB to pre-commit in return, which seems to us very unlikey at this time.

…as politics between North and South might get in the way

However, the ECB has bought time for countries to put in place reforms. The question therefore becomes how fast countries put themselves under the ECB’s umbrella, and how much they then comply with their commitments. That is likely to be the outcome of a trade-off between economic and political arguments. For economic purposes, countries should put themselves in a Troika “light” programme very quickly and reform in this environment of financial market stability. However, politics may get in the way: ECB support is conditional on ex ante commitment to reforms, and this has political costs if the required reforms go beyond what the government in place had considered.

We argue:

Spain should soon ask for help, while;
euro area governments, as well as the ECB, will need to provide incentives for Spain to request support as fast as possible: provided Spain commits to reforms, this would lead to a more stable situation, whereby Spain reforms and ECB shields it from financial market volatility.

However, it is more likely that Spanish politics will get in a way of a rapid solution. Overall we expect discussion on conditionality to be announced soon –possibly as soon as the Ecofin meeting 14 September- but not necessarily concluded rapidly, leaving official request for support for later, when higher yields will eventually push Spain to ask for support.

Once Spain asks for help, we believe that it will be difficult for the ECB to enforce conditionality. Should Spain fail to comply with the agreed conditions, the ECB support is likely to remain for awhile, as pulling the plug could lead to substantial market turmoil, with potentially systemic implications. However, eventually Spain could possibly need a full sovereign program, if lack of reform implementation were to lead to ECB exposures that were too large for the Eurozone core countries to accept.

OMT programme designed to stabilise euro area

The ECB’s Outright Market Transactions (OMT) programme resembles the QE of the Fed or BoE, under which in order to lower rates they purchased their respective sovereign debt. But unlike the Fed and the Bank of England, the ECB has set conditions for the governments it helps out. In practice, however, the ECB has no real power to enforce its conditions ex post, i.e. once the country is in a programme.

As soon as a country is in an ECB support programme, the bank will have to continue its purchases, because not doing so would risk destabilizing the entire euro area. Hence, the ECB cannot really hope to drive economic reforms in the euro area; rather it seeks, more simply, to ensure the stability of the euro area:

we expect Spain to request support with some delays, as the government tries to minimize conditionality and the resulting political cost (see here for discussion of this issue)
the ECB support, though it will be always there, may appear to vary with reform implementation to avoid criticism of government financing.

OMT programme a powerful weapon against speculation

The ECB programme can be summarized as follows:

The ECB buys short-term maturities in the secondary market to supplement EFSF/ESM buying of longer maturities in the primary market and safeguard continued market access, keeping yields at relatively low levels
The country has to meet a set of fiscal conditions agreed with the ECB, other euro area governments, and the IMF (based on existing euro processes such as fiscal surveillance and macro economic imbalances surveillance)
The threshold for yields or spreads is not defined, thereby preventing markets from testing the bank’s response capability; this also gives the country the option to ask for support or not.

This is a conditional backstop. To use a metaphor, the ECB has offered a seatbelt to a driver with a bad driving record, which will only work if the driver agrees to a strict monitoring of his driving. So, will the driver accept the offer in the first place? Will he change his behaviour afterwards? And if not in the latter case, is the threat of removing the seatbelt credible?

Markets are cautioned that the ECB will do everything possible to counter yield increases, since its ability to purchase debt is unlimited. Countries know they can rely on its firepower in the event of “undue” market pressure. The ECB programme is therefore a powerful weapon against speculation that is not fully justified by fundamentals and policy plans. It addresses concerns that the crisis firepower would not be enough for Spain and Italy even if these two countries are willing to implement the needed reforms. It could also protect them from external shocks, such as a further deterioration of the situation in Greece.

The programme acquires respectability by being conditional on a set of economic reforms defined by the country, the governments of the euro area, the ECB, and the IMF. The idea is that by providing an incentive to encourage reforms the ECB avoids the criticism that it would be monetizing unsustainable deficits. The ECB intends to discontinue support if a country does not comply with the agreed conditions. In this sense, the ECB would appear to have quasi-sovereign power over a country’s economic policy, since it defines and tries to force the policies to implement. This is very different from what the Fed and the Bank of England have done.

ECB threat of abandonment for non-compliance not credible…

At first sight, the bank’s intervention is strictly conditional: it requires the signing of a MoU, i.e., a commitment to implement reforms and controls, an ECCL programme that is signed for one year, renewable for a period of six months, twice. In addition, should the country continue to fail meeting the conditions, intervention would become conditional on a full sovereign programme, similar to that of Ireland and Portugal. But how could the threat of cutting off purchases in the event of non-compliance be credible: what would the ECB do if a country from which it has bought up a large quantity of debt no longer meets the requirements of the MoU and yields were rising rapidly?

…leaving a country at the mercy of the market would destabilise euro

As soon headlines such as "the ECB no longer supports Spain as it does not meet its commitments" hit the wire sovereign yields would soar, the country would be denied market access, raising the question of default and its systemic effects on the euro area banks. This would have potential spillover effects on other fragile countries, such as Italy. After all, Greece has been missing its program conditions for more than a year and the European authorities – including the ECB through its support to the Greek banks – have not stopped funding the country. Given the absence of credibility when it comes to enforcement, we identify two types of equilibrium in the short term:

Unstable equilibrium: the conditions imposed for access to ECB support are such that the country has no interest in seeking help, and the ECB remains "respectable" by not intervening.
Stable equilibrium: the conditions are milder and the ECB intervenes quickly and potentially buys up large amounts of debt.

In the first equilibrium scenario, as the ECB knows it does not have the means to carry out its threat to stop purchases of debt, it seeks to deter countries from requesting support in the first place. The conditions it sets are so harsh as to preclude any request for support. An IMF-style programme would likely deter Spain:

Ireland is recovering slowly, but thanks to its strong export capacity; and Portugal is in a recession for the second consecutive year and its growth prospects and ability to restore its public finances are weak and looking increasingly remote. Furthermore, the political cost implied by the loss of sovereignty associated with these programmes is also a deterrent. Spain, with the prospect of regional elections in late October and arguing that it has put the right reforms in place would have little reason to ask for ECB support while it can fund itself.

Alternatively, in the second equilibrium scenario, the ECB provides an incentive to request support. Conscious of its lack of coercive power the ECB does not wish to put this to the test so the aim of the OMT programme is to prevent speculation against euro area member states and the viability of the euro itself. In this scenario, the ECB lowers the cost of entry into a programme by offering very mild conditions.

For example, in the case of Spain it might require no more than the implementation of ongoing reforms (and no additional fiscal austerity or pension reform). For Spain the cost of seeking support would be little more than the political cost associated with a programme (though the ECCL is designed to minimise that) and the cost of an audit of its public finances. It would therefore be in the interest of Spain to seek help quickly and request the protection of the ECB.

Spain is likely to be pushed into asking for support

To gauge whether Spain (or Italy) would ask for support we need to assess whether the first equilibrium is sustainable over time. The answer would only be ‘yes’ if Spain’s public finances were clear, deep economic reforms were progressing and growth likely to be renewed quickly. In contrast, repeated fiscal slippage in Spain’s regions, where spending accounts for 40% of total public expenditure, suggests that an external audit of public finances in Spain would bring transparency (lacking today) that could reinforce market concerns. Markets are struggling to assess the quality of structural reforms, and their effects are becoming visible only slowly. Growth prospects are dampened in Spain: fiscal adjustment and deleveraging of the banking sector will, in our view, weigh on the economic dynamics of Spain for many months.

The stable equilibrium of immediate support is the most desirable outcome, but politics may lead to an unstable equilibrium

Overall, the likely outcome will be somewhere in between the two equilibria. Given the political reluctance of countries to request official support and submit to externally unforced conditionality, accepting reforms, transparency and apparent loss of sovereignty, there will likely be delay in Spain officially applying for ECB/EFSF support, though European Finance Ministers may announce negotiations on the conditions at the Ecofin meeting of 14 September. Once Spain is in a programme, in case of slippage, we would expect some instability to continue, albeit possibly at a more modest level.

Indeed, there is an implicit limit to ECB’s support in case of slippage: that is a political limit and how much Germany and northern European countries are ready to see the ECB purchase debt without this disrupting their internal political landscape. The combination of potential political tension and ECB purchases, even in case of slippage but with a view to preserve the euro, means that the euro area is likely to remain subject to some tensions and episodes of volatility, until the ECB is fully tested as a backstop, which could take some time.

The case of Italy is more complex. If Spain asks for official interventions, this should take pressure off, at lease temporarily, from Italy, especially while the redemption schedule is fairly modest October- November. Given ECB Draghi's remarks and the overall economic and policy implementation performance of Italy since PM Monti took over, we think Italy should classify for an ECCL: a precautionary line, subject to ex ante and ex post monitoring, but where conditions should broadly coincide with the policy commitment agreed in the EDP and MIP. We think that this option implies that the "political hurdle" to sign up is much less than a full programme, but still not desirable from the political parties' point of view before the elections and therefore resisted if yields remain manageable.

Is the positive market sentiment (and EUR strength) sustainable?

The Euro has strengthened as the yields in Spain and Italy dropped sharply in response to the ECB bond-buying plan. Although, in our view, the ECB’s conditional backstop is some way from the “bazooka” that many were expecting, such expectations were unrealistic to begin with and were gradually adjusting closer to the meeting. Very light market positioning also supported risk appetite once the ECB event risk went by without a disappointment. Renewed expectations of QE3 in the US following disappointing nonfarm payroll data and the positive Constitutional Court decision in Germany on the ESM also supported the Euro.

Looking forward, the above discussion suggests limited room for further upside. If Spain officially asks for help soon, which is not very likely in our view even though discussions over negotiations are ongoing, yields could decline further and the Euro could appreciate, but not far from current levels, as we believe that a lot is priced in already. A delay, however, could eventually trigger new market concerns, with negative market implications. In terms of the Euro, whether the Fed will proceed with QE3 in September, or it will give a strong signal that QE3 remains likely before the end of the year is likely to determine the short-term outlook of the currency.

OMT sterilized but little impact on ECB balance sheet as banks still determine total liquidity in the system

The OMT purchases will be sterilized, i.e. the ECB will absorb back the money created, likely by issuing 7-day fixed-term deposits every week, as was done for the sterilization for the SMP. Bidding in the tenders for these 7-day fixed-term deposits is not compulsory, therefore the amount of bids may vary – In fact, several “failed” sterilizations happened in the past.

That said, as we argued before, even if the ECB is not able to sterilize the full amount of its purchases on a certain week, this would not be problematic per se. The ECB has already ceded the control of the amount of liquidity in the system to the banks with full allotment in its regular repo operations. A failed sterilisation can be interpreted as being equivalent to a full sterilisation coupled with higher borrowings at the weekly 7- day repo operation.

Moreover, the 7-day deposits are also eligible securities for repo operations, and overnight marginal lending facility, meaning that even if a bank parked its money in the 7-day deposit facility, it could still get back some cash on that week, albeit at a cost (the marginal lending rate charged by the ECB being higher than the rate paid by the ECB on the 7-day deposit).

Hence, we would argue that the whole idea of sterilization to ensure a “neutral” effect on total money supply in the economy is merely to help calm fears (and avoid critics) that ECB bond purchases could be inflationary, even though it has no real impact in practice.