In his highly anticipated press conference on Thursday, Mario Draghi, the European Central Bank president, delivered the news he was expected to deliver and a very misleading explanation of why it happened and what it means.
Under a new program called Outright Monetary Transactions, or OMT, formally approved by the ECB's governing council, the ECB is prepared to throw its weight behind future bailouts of Eurozone member countries by buying potentially unlimited amounts of their shorter-dated state bonds.
It was an important decision, but not for the reasons Draghi gave. Because OMT's real purpose is controversial, the program was approved under a pretense of being aimed at easing credit conditions in private credit markets.
OMT brings the ECB uncomfortably close to breaking the rule in its charter that forbids it from financing governments. The ECB will be indirectly lending to governments, by buying bonds from third parties who buy them from governments. That doesn't break the letter of the rule, but many people - including Jens Wiedmann, the Bundesbank president - believe it violates the rule's spirit.
So in order to smooth OMT's approval, Draghi constructed an elaborate excuse that allows the ECB to pretend it's acting in the interests of monetary policy. According to this legend, the ECB has lost its ability to lower interest rates in some Eurozone countries because of unfounded fears they will leave or be kicked out of the Eurozone.
Buying those countries' shorter-dated sovereign bonds will prove those fears unfounded and fix the "transmission mechanism" by which the ECB controls Eurozone interest rates, Draghi explained at the press conference.
Draghi's story went over beautifully with the ECB's governing council, which passed the plan with only one dissenting vote. Since Wiedmann's opposition is well known, that means even Jörg Asmussen, the other German on the council, approved.
And yet Draghi's story is all horsefeathers. OMT is aimed mainly at Spain and Italy, the two crisis countries that are considered least likely to exit the Eurozone. ECB purchases of their state bonds will do very little to stop the tightening of their credit conditions, which are being driven by economic recession, rising default rates and bank illiquidity.
The ECB's real aim is to help fund make bailouts of Spain and Italy financially feasible. OMT is meant to cover the shortfall between the amount of money Eurozone governments have budgeted for bailouts and the projected demand from crisis-hit countries for bailout funds.
The Eurozone's current bailout fund, the European Financial Stability Facility or EFSF, and its planned successor, the European Stability Mechanism or ESM, were allocated a total of €940 billion in lending capacity. The EFSF has already committed €188 billion to the bailouts of Greece, Portugal and Ireland. Another €100 billion to recapitalize Spanish banks is being negotiated.
The remaining €652 billion isn't nearly enough to fund bailouts of Italy, Spain and Cyprus and extend the bailouts of Ireland, Portugal and Greece. But attempts to boost the ESM's funding have been vetoed by Angela Merkel, the German chancellor, who fears being punished by resentful German taxpayers in elections next year. One of the main reasons for investors to flee Spain and Italy has been the perceived lack of money to bail them out.
By stepping in with its unlimited spending power, the ECB will change those calculations. In fact, markets did most of their adjusting back when Draghi first hinted at his plan in late July. Spanish and Italian government borrowing costs have come down significantly, especially for shorter-term debt.
But private lending conditions haven't much improved. In Spain, they appear to have tightened.
Spain Debt Deflation Accelerates
The recent news from Spain is as grim as I explained last month. Some of the news is even grimmer.
Many readers will have seen the report that Spain lost a staggering €74 billion of bank deposits in the month of July alone. And that was just an incomplete advance release. More detailed data published this week shows that Spanish banks actually lost €88.5 billion of deposits in July.
That figure can be calculated by taking the €73.3 billion total drop in "deposits" reported by the Spanish central bank and subtracting from it the €15.2 billion of growth in July of interbank and central bank financing of Spanish banks - which, oddly, are counted among deposits in Spanish statistics. (The numbers are here in table 8.3 column 6, 8.10 column 5, and 8.13 column 3.)
The data also confirm, as I explained last month, that Spanish bank deposits are shrinking for two reasons: deposit flight and debt deflation. When repayments of bank credit are greater than new bank credit, the supply of bank deposits shrinks.
The July drop in deposits mainly reflected accelerating debt deflation. Deposits from domestic corporations shrank by €55 billion while bank loans to them shrank by €22 billion and bank holdings of their debt securities shrank by €24 billion. Deposits from households shrank by €10 billion while bank loans to them shrank by €6 billion.
A €7 billion drop in public sector bank deposits owed mainly to light public debt issuance in July. Actual deposit flight in July was also rapid, driven mainly by foreigners who withdrew €16 billion of deposits from Spanish banks during the month.
On the other hand, capital flight via bank transfer to the rest of the Eurozone slowed sharply in July to €15 billion from €63 billion in June. ECB statistics showed average rates on new long-term loans to Spanish business dropping sharply in July, from 6.57% to 5.17%.
Given the big shrinkage of outstanding business loans during the month, that seeming easing is likely a mirage. The lower average rates likely reflected a higher quality pool of borrowers as credit standards tightened and demand for credit fell.
Details Left Unclear
Since Draghi began talking about ECB bond-buying in late July, analysts have been guessing details of how his plan would work in practice. After Thursday's press conference, we're still guessing.
One key issue is whether the ECB's financial support will allow governments to receive bailouts with lighter austerity and reform conditions than they would have to accept if they depended solely on the IMF and the EFSF or ESM. The answer appears to be yes, or maybe no.
An ECB statement read by Draghi before the press conference said bond purchases could be activated only in combination with "strict and effective conditionality attached to … a full EFSF/ESM macroeconomic adjustment programme or a precautionary programme (Enhanced Conditions Credit Line)."
The EFSF offers two different kinds of credit lines: a Precautionary Conditioned Credit Line (PCCL), with light conditions, and an Enhanced Conditions Credit Line (ECCL), with stricter conditions more similar to the "full macroeconomic adjustment programs" as seen in previous Eurozone bailouts. The word "precautionary" in the statement suggests that a PCCL with its light conditions would be enough to activate OMT.
But when asked, Draghi seemed to deny that the ECB would buy bonds with only light conditions and seemed to say that the OMT could only be used in combination with an ECCL or a traditional full bailout. On the other hand he didn't directly address the question of whether a PCCL would be enough to activate OMT.
Here's the full text of the question and answer (my transcription):
Journalist: I want to ask if the inclusion of the feature of the precautionary program was made thinking of countries like Spain or Italy, which have refused the idea to go under a full macroeconomic adjustment program.
Draghi: No, no, the answer is no. It was basically the common view that that provides a fair, it's not only that, of course you also have the possibility of a full macroeconomic adjustment program, and they were considered the two forms of broad conditionality and involvement of all the other Euro area governments.
Journalist: Yeah but Mr Draghi that doesn't mean a soft bailout feature?
Draghi: Oh no, not at all. You should look at the conditionality of the ECCL. Not at all. It's a full macroeconomic conditionality and it would also see the very likely involvement of the IMF.
Another key question is what interest rate levels the ECB would target. Draghi gave vague answers to that question, leaving the impression that the ECB will decide as it goes along. He admitted that high rates in crisis countries partly reflect "the quality of the outstanding credit of these countries," which suggests the ECB won't drive down their bond yields as low as those of healthier countries.
Another issue is whether the ECB and the EFSF or ESM will coordinate the maturities of bonds that they'll be buying. One possibility is that the EFSF or ESM would buy the same, shorter maturities as the ECB, to preserve a semblance of market discipline through less-manipulated prices for higher maturities. Another possibility is that the EFSF or ESM would buy longer-dated maturities, so the bailed-out country could effectively sell its entire net issuance either directly to the EFSF or ESM or indirectly to the ECB.
I assumed in my previous article that the EFSF and ESM would buy the same shorter-dated maturities as the ECB because Draghi said at his Aug. 2 press conference that preserving market discipline was part of the reason the ECB would not buy longer maturities. At Thursday's press conference, Draghi gave a longer list of reasons for buying only shorter-dated bonds that notably did not include market discipline. So now I'm less sure.
A third important question concerns the ECB's decision to not claim seniority for the bonds it buys through OMT in the event of a restructuring. That could be important - and a potential rip-off of Eurozone taxpayers. Or it could be a meaningless diversion.
It depends on who would pay for the ECB's losses in such a restructuring, whether more loans would be extended to the country after the restructuring and who would fund those loans.
In the Greek restructuring, post-restructuring loans were funded entirely by public creditors, including Eurozone governments and the IMF. Since public creditors were providing the funds with which Greece would repay private creditors, public creditors insisted that private creditors take all the write-downs. That was only fair.
I can think of three situations in which it would be fair for the ECB to accept pari passu status with private creditors: if the restructuring included no post-restructuring credit, if private creditors participated equally in providing post-restructuring credit, or if the restructuring country were forced to compensate the ECB's losses through the inclusion of earmarked funds in the post-restructuring credit.
In the first two cases private creditors would deserve pari passu status with public creditors. In the third, private creditors would be forced to take just as big write-offs as if the ECB were senior.
On the other hand, if in a future restructuring Eurozone taxpayers had to solely fund post-restructuring credit, and on top of that they had to also pay for the ECB's losses in the restructuring, that would be a royal rip-off of taxpayers and a sheer gift to private creditors.
I think the latter scenario would be politically difficult to pull off, and investors would be unwise to bank on it.