ECB Launches Bond-Buying Program: Bazooka Or A Fizzooka, Time Will Tell

Draghi said the ECB is prepared to buy government bonds in unlimited quantities in order to eliminate harmful distortions in financial markets fueled by fears of a eurozone breakup, but reiterated that participating countries must promise to abide by strict conditions.

The new program, dubbed Outright Monetary Transactions, or OMTs, “will enable us to address severe distortions in government bond markets which originate from, in particular, unfounded fears on the part of investors of the reversibility of the euro," reported Bloomberg. The scheme, to which Germany’s Bundesbank reiterated its opposition, would focus on bonds maturing within three years and was strictly within the ECB’s mandate, Draghi said.

“Under appropriate conditions, we will have a fully effective backstop to prevent potentially destructive scenarios,” Draghi told a news conference after the central bank’s monthly meeting On Thursday. “No ex-ante quantitative limits are set on the size of outright monetary transactions,” he said, using the formal term for ECB bond-buying programs.

Draghi said the ECB would only help countries that signed up to and implemented strict policy conditions, with the Eurozone’s rescue fund also buying their bonds, and preferably with the IMF involved in designing and monitoring the conditions. Draghi also said the ECB was prepared to waive its senior creditor status on bonds it purchased – meaning it would be treated equally with private creditors in case of default. The central bank hopes that by removing private investors’ concern about being paid back last in the event of a sovereign default, they will not head for the exits if the ECB intervenes and buys bonds.

ECB President’s decision to buy unlimited amounts of short-term government debt is likely to prompt a positive market reaction. However, on the downside, it transfers far more risks from struggling banks and governments onto the ECB’s balance sheet, without providing any fundamental solution to the crisis. By focusing on the short end of the market, the ECB action could lead to a sharp steepening of the yield curve in financially stressed eurozone countries that could aggravate attempts to boost credit flow from the core of the region.

The ECB may in most probability fail to impose effective conditionality which could actually prove to be a disincentive for Spain, Italy and others to instill strict reform measures, making the crisis worse in the long-term. Buying short-term maturities is less risky and will pull down yields across the board, reducing borrowing costs.

It also could free up cash in peripheral banks to lend more or purchase more domestic sovereign debt. Buying up this debt could exacerbate the shortage of quality assets to post as collateral at the ECB for struggling banks as a large amount of short-term sovereign debt is posted as collateral for borrowing from the ECB.

As seen with LTRO, the money may not flow into riskier assets but be hoarded and used to ease bank funding pressures. This may also encourage nations to issue more short term debt, making them more susceptible to changes in borrowing costs and more reliant on the ECB. The crucial issue of the Transmission of Monetary Policy to the real economy has yet not been effectively addressed to but the new decision in fact could make it worse, if it succeeds in encouraging banks to load up on domestic sovereign debt.

ECB President Dragi wins required Support:

Pressure on Draghi intensified after an unsubstantiated German newspaper report last week that Bundesbank chief Jens Weidmann had considered resigning over his opposition to bond-buying, although several sources say he has made no such threat and believes in staying at the table to argue his case. Draghi succeeded in securing overwhelming support on the Governing Council for the plan despite Weidmann’s opposition.

“In the most recent discussions, as before, Bundesbank President Jens Weidmann reiterated his frequently substantiated critical stance towards the purchase of government bonds,” the German central bank said in a statement. “He regards such purchases as being tantamount to financing governments by printing banknotes,” it added.

Other ECB policymakers saw a greater urgency to help Spain and Italy and prevent the eurozone crisis from deepening. In another potential sop to the Bundesbank, Draghi said all bond purchases would be “sterilized” by taking in an equivalent amount in deposits from banks to avoid any risk of inflation.

ECB will not target specific Bond Yields:

ECB debt purchases – which would succeed the bank’s Securities Markets Programme that has been dormant since March – would be suspended if countries did not comply with the terms. With Germany’s constitutional court not due to rule on the new ESM rescue fund until next week, there was no prospect of the ECB intervening immediately. Highlighting the eurozone’s economic predicament, Draghi said growth in the region would recover only gradually.

Fresh ECB staff projections pointed to the economy contracting this year by between 0.2 and 0.6 percentage points. One downside for policymakers may be an increase in commodity prices, which were buoyed by the ECB announcement, reported Reuters.

Most Welcome the ECB Plan:

Equity Markets cheered and Bond Markets applauded the announcement, which was largely in line with earlier news reports on the likely outline of the program. International Monetary Fund chief Christine Lagarde welcomed the new ECB bond-buying programme and said the global lender was ready to cooperate “within our frameworks.” Spanish Prime Minister Mariano Rajoy and German Chancellor Angela Merkel said they did not discuss conditions for aid for Spain, despite expectations Rajoy would seek Germany’s support for a bailout in a bilateral meeting in Madrid on Thursday.

Italian Prime Minister Mario Monti welcomed the European Central Bank’s decision to launch a bond-buying program to reduce bond yields without saying whether Italy would ask the ECB for help to lower its own borrowing costs. “Today there’s been an important step forward – after the decision of ECB President Mario Draghi – toward more satisfactory eurozone governance,” Monti said.

ECB Conditionality to Bond Buying:

Linking conditionality to ECB purchases on requests from the eurozone bailout funds, the EFSF/ESM is in order to ensure that ECB cash does not replace the necessary reforms. Imposed conditionality norms may be far from enough to counter this moral hazard. Previous bailout programs have shown the eurozone is generally hesitant to revoke funding even when conditions are breached.

It will be almost impossible for ECB to effectively enforce conditionality without having a fully-fledged political body status, which would most certainly violate its mandate. ECB only has the option to withdraw funding which will be extremely difficult to do without causing huge market distortions. No concrete or logical exit strategy has yet been arrived at for borrowing nations to exit ECB funding. By way of sterilized purchases the ECB means it will take in liquidity from the market equal to the amount it injects with its bond buying.

Sterilization is ultimately a matter of semantics when a central bank commits to “unlimited” liquidity provision and bond purchases. This is especially true since ECB deposit certificates can still be used as collateral for borrowing from ECB, meaning the liquidity the ECB removes with deposits can simply be recycled through its own liquidity provision. The rates or maturity of the sterilization process will dictate how successful the sterilization will be. If rates are too low then sterilization may fail, if they are too high banks could be encouraged to hoard cash at the ECB, limiting the effectiveness of the program.

ECB purchases of debt will likely be senior under a restructuring which would mean the ECB will not take losses under a restructuring, thereby increasing the potential loss for investors. Under the OMT Draghi state purchases would be senior. The decision to widen collateral rules suspends the minimum credit rating requirement for government or government guaranteed bonds from bailed out countries used as collateral at the ECB.

This may ease the problem of lack of collateral in struggling countries, but will also transfer far more risk onto the ECB’s balance sheet, particularly in the form of junk bonds guaranteed by financially unstable governments such as Greece, Spain and Italy if and when they have entered bailout programs and then fail to implement conditionality.

Azad Zangana, European economist at Schroders in London, said the ECB has pulled out a big gun, but that its insistence on sterilizing bond purchases robs it of ammunition, “reported Market Watch. The ECB’s insistence to sterilize the bond purchases means the ECB can only buy bonds as long as demand for euro T-bills remains,” Zangana said in emailed comments.

That’s because the ECB absorbs the extra liquidity put into the financial system by its bond purchases by selling T-bills. “If demand dries up, as it did [under the ECB’s previous bond-buying program] at the start of the year, then the bond purchases would be halted,” Zangana said. “In that sense, Draghi may be overreaching when he said the ECB would ‘backstop’ the monetary union.”