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The unscripted comments on July 26 by Mario Draghi, beleaguered president of the European Central Bank (ECB), will be remembered as one of the more effective cases of verbal market intervention in recent history. Spanish two-year yields dropped from record levels of around 6.5 percent then to 3.5 percent, and Italian two-year yields likewise are down from around 5 percent then to around 2.75 percent today. If nothing else, the ECB president bought time to reach agreement on what to do next while Europeans could calm themselves in the August holiday season.
But what can be expected on September 6, when Draghi is expected to detail plans to do "whatever it takes" to preserve the euro? The peripheral bond market rally since late July has priced in some sort of ECB action already. But the slowdown in the euro area has remained over the summer even as the Spanish and Italian governments are planning to return more heavily to the primary markets. A sizable market sell-off could occur if ECB's actions fall short.
In August, Draghi provided some insight into how the ECB intends to act. The ECB Statement is worth quoting in full:
In order to create the fundamental conditions for such risk premia to disappear, policy-makers in the euro area need to push ahead with fiscal consolidation, structural reform and European institution-building with great determination. As implementation takes time and financial markets often only adjust once success becomes clearly visible, governments must stand ready to activate the EFSF/ESM [European Financial Stability Facility/European Stabilization Mechanism] in the bond market when exceptional financial market circumstances and risks to financial stability exist—with strict and effective conditionality in line with the established guidelines.
The adherence of governments to their commitments and the fulfillment by the EFSF/ESM of their role are necessary conditions. The Governing Council, within its mandate to maintain price stability over the medium term and in observance of its independence in determining monetary policy, may undertake outright open market operations of a size adequate to reach its objective. In this context, the concerns of private investors about seniority will be addressed. Furthermore, the Governing Council may consider undertaking further non-standard monetary policy measures according to what is required to repair monetary policy transmission. Over the coming weeks, we will design the appropriate modalities for such policy measures.
In contrast with countries that have their own central banks, ECB financial assistance to euro area national governments does not come for free. Recipient governments have to pursue fiscal consolidation, structural reform, and European institution building, and must apply for a conditional EFSF/ESM bailout before any assistance from the ECB, which may or may not help a euro member even if the EFSF/ESM acts. The ECB is evidently intent on retaining its total discretion over its balance sheet. Chancellor Angela Merkel of Germany is obviously not the only one who assigns homework to elected leaders in the euro area these days.
A second aspect of the Draghi statement is that ECB assistance will come in the form of outright open market interventions. Thus any bonds purchased will presumably go directly on to the ECB balance sheet, which means that seniority concerns of private investors must be addressed. In other words, the ECB intends to keep for itself as much control as possible over any market assistance. Letting the ECB provide leverage to the EFSF/ESM or giving the ESM a banking license is evidently not under consideration in Frankfurt.1 Bonds will be purchased directly by the ECB at its own discretion. But to facilitate accountability, the central bank will provide more information about the identities of individual sovereigns and amounts purchased, probably after some time delay.
In his responses to questions, moreover, Draghi made it clear that the ECB would focus on the short end of the yield curve in any assistance, giving the ECB the future ability to "twist" any bond purchases while leaving it to euro area governments to act to bring down the cost of their long-term debt. Finally, the ECB made it clear that it might innovate again with further non-standard measures.
What more should markets expect this week?
It is evident that the ECB's focus is not financial markets but rather elected euro area politicians. As pointed out on this blog, the crisis and the unfinished nature of the euro area have bestowed upon Frankfurt the unique ability to coerce political leaders to take action. It is safe to assume that the ECB will want to retain this power to protect itself against moral hazard and to avoid the precedent regretted by several Governing Board members regarding Prime Minister Silvio Berlusconi of Italy in 2011, when the Italian government reneged on reform promises after getting ECB assistance.
Consequently, future ECB interventions are likely only after a euro area government has approached and been granted EFSF/ESM assistance, and the EFSF/ESM has committed its own money by, for instance, buying its bonds in a primary auction. To protect itself against moral hazard, the ECB is thus likely to demand that euro area governments commit their own money first. This need not imply undue delays, because the EFSF/ESM program can be authorized quickly. But the process has obvious political significance.
The ECB is also likely to retain discretion over the quantity, price, and duration of any bond market interventions to assist euro area governments. It is almost inconceivable that the ECB will establish explicit quantitative parameters and targets for any future interventions. There will be no explicit country bond yield caps or targets. Their establishment could put the ECB in the situation of having to defend them in the name of broader euro area financial stability, irrespective of the actions of beneficiary governments. This would again expose the ECB to the situation it was in with Berlusconi last year. There is also not likely to be a limit on ECB interventions and interventions. They will remain open-ended in scale, provided that euro area governments comply with ESM/EFSF conditionality.
Without explicit quantitative targets, what goals will the ECB seek through its interventions?
In early August, the ECB indicated that it intends to remove the exceptionally high risk premiums hindering the monetary transmission mechanism in the euro area. In an extreme interpretation, this could be taken to mean that the ECB would want to restore the pre-crisis convergence among at least shorter maturity euro area sovereign bond yields. That, however, will never happen. The ECB would then be taking away the very incentive for euro area governments to respond to market signals, opening the door for moral hazard.
Instead, the ECB will want to bring down peripheral country short end sovereign bond yields from the highs of late July to levels that sustain their long-term fiscal solvency and economic fundamentals while delivering a monetary easing for the non-financial sector. This should lower loan rates for peripheral small and medium enterprises (SMEs). Short-end yield curve price spikes will moreover have to be prevented by ECB interventions, because peripheral country governments are effectively surrendering their fiscal and economic sovereignty in return for ECB protection from sudden market funding "strikes."
Without explicit targets for "acceptable" risk premiums, the ECB's interventions can be expected to be flexible, and indeed opportunistic in nature. Any implicit secret ECB yield target would not only be surrounded by point estimate uncertainty, it would also change in response to macroeconomic developments and government policy compliance. And one probably should not rule out the ESM/ECB desire to burn a few of those hedge fund types carrying out "euro shorts" either.
No doubt to the great joy of my colleagues C. Fred Bergsten and John Williamson, the ECB is likely to operate in the bond markets in a manner functionally adhering to a wide (shadow) exchange rate target zone, while retaining the discretion over when and how to intervene.
Given the three-year duration of the unlimited long-term refinancing operations (LTROs) previously provided to euro area banks by the ECB, it seems likely that short maturities will not exceed three years for any sovereign bond market purchases.
There is also the issue of which euro area peripheral countries would be eligible and likely recipients for this type of EFSF/ESM and ECB financial assistance. Spain and Italy are the obvious candidates for which this option was arguably designed—i.e., conditional financial support for countries that seek to remain in the markets. As mentioned earlier on this blog, the German Constitutional Court will not likely rule the ESM unconstitutional. I expect this policy option to be operational after its September 12 ruling. Given Spain's large bond redemptions in October, the government of Prime Minister Mariano Rajoy in Madrid will make a formal application to the ESM by early October. Italy's financial situation is less acute, and there is no obvious short-term trigger for a similar application. But it seems most likely that Prime Minister Mario Monti will apply for a similar type program before the EU Council in December 2012. He is, after all, under political pressure from other euro area leaders, responding to the new financial market disadvantages vs. Spain, and the domestic political desire to tie the hands of his successors after his departure next year. Rome's political establishment, under threat by populist Beppe Grillo, also has an interest in pushing responsibility for years of continued unpopular austerity on to Monti and the ESM. They can thus be expected to support his reforms in parliament later this year.
A somewhat different logic pertains to the three small peripheral IMF program countries, Greece, Portugal, and Ireland. As IMF program recipients, they do not pose the issue of political moral hazard for the IMF, the ECB, or the euro area. An obvious if unarticulated division of labor for the Fund has emerged in this crisis. The IMF deals directly with small countries in its traditional program approach, while the euro area and ECB support the two too-big-to-bail countries, Spain and Italy. Thus Greece, Portugal, and Ireland will not see direct purchases of their government bonds by the ECB in the short term. For the duration of their IMF programs, they are highly unlikely to apply for such purchases. But after the IMF program expires, they will have the option to apply for support from the EFSF/ESM as Spain and Italy are doing now. This additional option, combined with the generally stabilizing effects on the euro area of such ECB interventions, should help Portugal and Ireland regain full market financing in 2013.
There is also the issue of seniority for any bonds purchased by the ECB. The central bank says that such concerns will "be addressed." But that may not be easy. Such "seniority concerns" are driven by investor sentiment, which has been somewhat irrational on the euro area crisis. Seniority concerns arise from a belief by investors that other countries will follow Greece in restructuring its debt, with associated haircuts. It may not be straightforward for the ECB to assuage such concerns, haunted as it is by the ghost of Greece in investors' psyches. It remains extremely unlikely that the ECB will ever take any direct financial losses on any euro area government bonds it has purchased throughout this crisis. This is because of the political troubles associated with securing an ECB recapitalization from 17 national parliaments. To erase any lingering seniority concerns, the ECB could take losses on its (previously excluded) Greek bond holdings, but such a step remains out of the question.
Instead, it seems likely that the EFSF/ESM would be called upon to absorb any potential losses in the official sector from bonds purchased by the ECB. Such a step would be reminiscent of the "sovereign guarantee" given by the EFSF to the ECB in return for its acceptance of default-rated Greek sovereign collateral. This could be facilitated in several ways. For example, the EFSF/ESM could purchase bonds at par from the ECB prior to restructuring. In this way, all bonds purchased by the ECB would ultimately end up being pari passu with private investors, even if the ECB itself remains a preferred creditor. Tail-end risk obsessed investors might well argue that the EFSF/ESM is too small to protect the ECB from the scale of a future Italian restructuring, so their concerns are not likely to be erased.
As for potential further non-standard measures, it seems unlikely that the ECB will launch large initiatives on September 6. Time is finite, and the scale of the potential bond purchasing program and of turning the ECB into the euro area's principal bank regulator demand the full attention of policymakers. More LTROs or new direct credit provision initiatives like the Bank of England's Funding for Lending scheme should therefore not be expected. On the other hand, it is possible that the ECB will follow up on its June 22 announcement to increase collateral availability for counterparties and present a new and reorganized framework for collateral eligibility, as discussed at the July 5 ECB press conference. This is a complex matter, but two directions seem clear. First, the revised system should provide more options for a targeted easing of collateral requirements for the euro area periphery. Second, the ECB should be expected to expand its discretion over deciding what bank collateral is eligible and what haircuts are called for. This discretion flows partly from the new regulatory powers it is acquiring over the EU banking system. As a result, the ECB will probably omit references to (at least) sovereign credit ratings in its collateral framework and instead set up its own evaluation process.
Finally, the opposition of the German Bundesbank and its president, Jens Weidmann, to any ECB bond purchases should not go unmentioned. To be blunt, this opposition reflects the impotence of the Bundesbank. Its opposition poses no relevant threat to the actions of the ECB. The reality in the euro area today is very different from the early 1990s—even if many an aged London-based market and media-based EMS-crisis veteran may not yet have noticed it. The Bundesbank has the same ECB voting weight as Malta. This "federal ECB structure" may not please some German observers, but since it is stipulated in the EU Treaty, there is nothing the Germans can do about it. The only impact of the Bundesbank and its president on an ECB policy is through its ability to sway German public opinion on the issue in question. Put another way, without the backing of the German government and/or large opposition parties, the Bundesbank will be powerless against the politically weightier opinions of elected German leaders, including Merkel and the main German opposition parties, who support Draghi.
In sum, this will be a critically important week for both the ECB and the euro area as a whole, even if there won't be many details or explicit targets provided.
Notes
1. The ECB clearly is opposed to granting the ESM a banking license and sees it a breach of the monetary financing prohibition in the EU Treaty's article 123. See http://www.ecb.europa.eu/ecb/legal/pdf/c_14020110511en00080011.pdf.
