Well, the news is in: The ECB president has finally revealed detalis of a plan (called Outright Monetary Transactions, or OMTs) to deal with the outflow of capital from the likes of Spain. Here are the main points:
- There will be unlimited ECB bond buying for bonds up until three years maturity
- This buying is conditional, countries have to sign up to the EFSF/ESM rescue funds
- The buying will be completely "sterilized" -- that is, the monetary consequences will be offset by selling other assets
- The ECB will give up priority creditor status for these purchases
- The EFSF/ESM might even be called upon to buy debt in primary markets (that is, direct lending to governments, which the ECB can't do)
The essential thing is the first, the unlimited buying. We have long argued that a mere ECB announcement to such an extent would be efficient and decrease the need for actual buying. The latter two points are safeguards that the ECB buying is not misused by countries to do nothing, and the third is a nod to the Germans that inflation will remain in check. With much of the eurozone in deep recession (if not outright depression), this is a rather theoretical risk, but it goes some way to placate German sensitivities.
The third element is simply to placate the bond markets, which (rightly) feared subordination and then big haircuts at the expense of private bond holders in case of debt restructuring.
Why is this necessary?
Simple. Spain isn't in a position to help itself and powerless to stem the outflow of capital that creates a self-reinforcing feedback loop, a vicious cycle that makes things worse, much worse. As a member of the eurozone, once investors doubt the viability of its fiscal and banking system, they sell.
Were Spain to have its own currency, such sell-off in its bond market would be partly offset, as those selling the bonds would also likely to sell the currency to move their funds elsewhere. This would likely lower the value of the currency (giving the economy a boost), and the buyers would reinvest in Spain. The liquidity cannot really leave Spain if it were to have its own currency.
But since Spain is a member of the eurozone, sellers of its bonds receive euros, which can leave Spain, and will. Just like the bank deposits. This capital flight greatly worsens the crisis, and there is little, if anything that Spain can do about it. Only the ECB is in a position to help, and now it has laid out how. This is most helpful, and as we long predicted, it had an immediate effect on Spanish yields.
The Spanish 10 year yield (a bond the ECB isn't even going to buy, as the program is for 3 year bonds maximum) fell 6% at the time of this writing (an hour after Draghi's speech Thusday).
Is this a game changer?
Well, not necessarily. It is able to break one vicious cycle -- the one raging between higher yields and fiscal sustainability. It could possibly break another one, with deposit flight draining bank balances (which then engenders more deposit flight). The jury is still out on that. However, there is other nasty stuff remaining.
The most intractable feedback loop is that of austerity leading to falling growth, tax receipts and a rising debt/GDP ratio. If anything, the surveillance part (where countries that sign up to the bond buying also have to sign up to EFSF/ESM conditionality) could reinforce this feedback loop. We have long argued for less emphasis on austerity and more on structural reforms.
Competitiveness gaps: In the first decade of this century, many of the peripheral eurozone countries accumulated an inflation differential with Germany and other core countries. To a considerable extent, this was produced by the euro itself, and the ECB setting its monetary conditions too much to stimulate growth in Germany in the first years of the euro.
But the internal devaluation route of restoring competitiveness is extremely painful. The deflationary efforts needed to increase competitiveness, leading to lower (negative) growth and very low inflation actually makes attaining a sustainable fiscal position that much more difficult.
Growth and a modicum of inflation would help reduce the real debt burdens, but worsen the competitiveness. It's a Catch-22 situation.
As long as the burden of adjustment falls exclusively on the deficit countries in the periphery, there is simply no easy way out of the latter problem. It would help enormously if Germany started to reflate, taking some part of the burden of adjustment upon the center countries.
In that light, it's somewhat disappointing that the ECB chose to sterilize all bond purchases. As recent (and not so recent) experiences with central bank bond purchasing programs have shown, the inflationary dangers are very low indeed, especially in such depressed economies as the eurozone periphery.
And then we have to wait until Spain signs up for an EFSF/ESM rescue package. That could be quite some wait. Over to you, Rajoy..
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