1992 Redux
The decision to use the ESM instead of the ECB to purchase sovereign bonds on the secondary market reminds me of the 1992 crisis. In broader terms, it raises the risk of a very traditional currency crisis in the Euro zone.
TARGET 2 can be seen as the equivalent to a German currency intervention aimed at stabilizing the exchange rate between Germany and other countries. It has so far prevented a break-up of the euro.
Currency intervention did not preclude the breakup of the European Exchange Rate Mechanism in 1992. The exhaustion of FX reserves of countries under attack forced the BuBa to intervene in the FX market, and then caused some of them to exit. The BuBa had to stop accumulating ailing countries' currency as it was against the stance of its monetary policy (tightening after the post-reunification boom). But there is more at risk than just the possibility of an unwilling BuBa to accept further TARGET 2 imbalances.
As I have written before, the Security Market Programme of the ECB is powerful, as there is no limit to the extent to which the ECB can use monetary creation to fight widening peripheral spreads. Switching from the ECB (that would only operate on behalf of the ESM) to the ESM makes a BIG difference as the ESM does not have unlimited resources.
This is clearly typical of the first generation currency crisis when fixed exchange-rate regimes would blow up as a result of the exhaustion of foreign exchange reserves.
i. Marking the ESM non-senior is good news as it does not crowd out private investors when a country is bailed out.
ii. Having an MoU signed by the recipient of the secondary purchases can ease the moral hazard issue linked with intervention without conditionality.
iii. But the crux of the problem remains: if secondary market intervention is not working, the floor of the ESM will be the equivalent of the depletion of foreign exchange reserves in the past.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
