Mario Draghi and the ECB lead the change in the Euro Area

Philippe Waechter, Economista Jefe de Natixis Asset Management - Miercoles, 12 de Septiembre

• 
• 
• 
• 
• • 
  • 
  • 

Mario Draghi and the ECB have sent a strong signal Thursday, September 6 at the press conference that followed the monetary policy committee. Proposals that have been made may indeed suggest that the crisis in the euro zone could finally find a solution that will maintain Euro Area entirety. Therefore perspectives are changing.  Because many questions are asked about the intervention, it seemed easier to make a series of questions / answers on the issues raised.

 

What are the objectives of the ECB in this operation?

 

There are two explicit targets. The first is again the irreversibility of the euro. This point was highlighted by Mario Draghi in London on July 26, recalled at the last ECB press conference on August 2, explained in an article published in the German newspaper "Die Zeit" on August 29. At this press conference Mario Draghi made a special focus on this irreversibility.

It has two components. The first is to maintain the euro zone as a whole and the need to implement the necessary means to achieve it. The second component is the institutional change that it implies. Mario Draghi made clear in his article for Die Zeit that he wanted fiscal and banking institutions that are Euro institutions and not an extension of local governments. He wants these institutions independent from local contingencies.

The second objective is to make more effective monetary policy implementation. In Spain and Italy long term interest rates are too high compared to ECB interest rates level. This means that there is not a good transmission from the monetary stance to the bond markets. In Germany or France long term interest rates are very low. This reflects the expectation of a very accommodative monetary policy for a very long time period. It is this failure that the ECB would like to reduce in order to allow the Spanish and Italian economies to benefit effectively from a very accommodative monetary policy.

 

What are the decisions taken by the ECB?

The outlines of the framework were presented by Mario Draghi at the press conference on August 2. He gave more details on September 6. A requesting country must make commitments on budgetary policy, structural reforms to be implemented and the European institutions. It will make an explicit request to the European Stability Fund (EFSF)/European Stability Mechanism (ESM). When these firewalls will approve the request, then the ECB will be able to intervene.This operation is called OMT (Outright Monetary Transactions)

 

The requesting country may do so in the context of a macroeconomic adjustment or on the basis of a precautionary program. In other words, it is not necessary to wait excessively to intervene. The EFSF/EMS may intervene in the primary market and the ECB on the secondary market but the ECB will not engage without an explicit commitment of the EFSF/ESM. This creates a strong conditionality for countries that request assistance. The countries that are currently under an aid program can use this ECB intervention scheme only if they are back on the bond market. This is not the case yet for all these countries as they are funded by different plans.

 

The intervention of the ECB is subject to the implementation of commitments made by the requesting country. If this latter does not respect all its commitments then the ECB will stop buying its bonds on the market. (However, see below)

The amounts involved are potentially unlimited and will be sterilized. The ECB does not want to increase the size of monetary aggregates through the purchase of assets in the secondary market. The ECB will redeem this liquidity by other means. It operates in a specific market (the country's debt applicant) but without disturbing its monetary policy strategy.

 

What is the difference with the previous program to repurchase debt (SMP)?

A program was implemented for the purchase of European debt. We remember a first intervention on Greek debt in spring 2010 and on Spanish and Italian debt in summer 2011. However, the impact was only temporary despite a total of EUR 220bn bond purchase.However, this program has not worked well because it was one-sided and lacking of transparency. Indeed, the ECB bought debt securities, on the long part of the yield curve, but without commitment from the states. It was a one sided operation. Moreover, the ECB did not give specific information on its purchases. The amount was available one week later on the ECB balance sheet but without details.

In the OMT program, things are different. The program is launched after the request of a country as it was explained above. The ECB will intervene only conditionally to this country and the EFSF/ESM commitments. Causality is not the same.

The ECB will give details on the type of operation that will be put in place.

Purchases will be on the short end of the yield curve (1 to 3 years), without defining an explicit target of interest rate or interest rate spread (eg with Germany).  Information on the amounts purchased and on the duration will be readily available. The amounts will be available every week and breakdown by country and duration will be available on a monthly basis.

 

Why focus on the short end of the yield curve of interest?

The intervention of the ECB will operate on the 1-3 years of the curve in line with the normal operations of the money market. The objective here is to weigh heavily on the short end of the curve. The intervention must be perceived as permanent to change investors' expectations and ultimately influence the entire curve.

One can imagine a very simple representation to understand the mechanism. Consider an economy with two periods. There is a short rate r for a period and a rate of two long periods R.

The market equilibrium rate is the following (1 + R)²  = (1 + r) (1 + r *) r * is the expected value of r for the second period. R and r are known today but r * will be influenced by expectations. Its implicit value will depend on the investors' expectations. The continuous involvement of the ECB and the requesting country's commitment must convince investors that r * will be low and stay low, pulling down R.

 

What will be the impact on interest rates in the Euro zone?

The objective of the ECB is to have bonds' interest rates consistent with its monetary policy. The goal is to have low interest rates across the euro zone as it is a necessary condition for growth resumption.

This could lead to adjustments on assets whose rates are currently very low, but the probability of a strong rise in German or French rates seems limited to me. Spanish and Italian rates are anomalous with respect to monetary policy and the economy, not the German or French rates.

 

What are the risks of the operation OMT?

We clearly see that the mechanism developed by the ECB under Mario Draghi's will could provide solutions to the Euro zone crisis. The difficulty is to imagine how the commitments taken by potentially requesting countries will be compatible with the deep recession that these countries are currently experiencing. We have Spain and Italy in mind here. Mario Draghi didn't give details on commitments. It is clear that if the commitments are translated into austerity policy with a too rapid reduction of the public deficit, the plan of the ECB will fail as a consequence of the economic downturn that will result. The risk is important because these two economies have high unemployment rates and a dynamic activity that is already very poor.

 

What happens if a country commits, let the ECB buy securities and does hold its commitments?

Mario Draghi stated that in this case the ECB bond purchases will stop. But certainly we can imagine a credible strategy that allows a country to expect that global growth restarts, benefits the economy in question and allow it to find the degrees of freedom on the budget and reform. At this point, the government could stop its commitments.

There may have what economists call the time inconsistency from the requesting country because at one point its interest may have changed. Short-term commitments will focus on public finances. Structural reforms take time to implement and to be efficient. Two goals with different time scales can lead to changing behavior.

Moreover, if the country stops in the reforms because efforts are too large then the ECB stop purchasing assets. But as the country is in trouble it can be found in default and the ECB, if it stops buying, will be penalized due to the devaluation of assets it holds in its portfolio. Therefore is the threat credible?

 

Finally, it is good or not?

Prospects may have changed with the ECB proposals. By the shape of its intervention the ECB is firmly committed under certain conditions. But the implementation of its action is entirely discretionary. It will take place without revealing target or timing. This uncertainty in the action but with a strong commitment is usually an effective way to intervene

By taking over part of the risk that is on the market via sovereign debt, the ECB fully play its role because it is the only institution that can take the risk on its balance sheet and spread it over time. This is why the ECB proposal is important. This action could give more prospects and the economic agents who will support less financial risks will be able to take new risks that could help to restore growth.

 

However, the Greek question is not settled. The probability of default or exit the euro zone for Greece is still high and will continue to have an impact on a kind of premium contagion to Spain. This is why a rapid response to Greece is necessary for the safe of the euro zone. This will help to find a more homogeneous dynamic not conditioned by an event that could have a strong impact.

The other point is that by taking this initiative Mario Draghi and the ECB lead the new structure that could be implemented in the Euro Area. They take an advantage on governments by proposing a new program and new institutions. The balance of power changes and may be at the end good news on the irreversibility of the euro zone.

 

[Volver]