By Rom Badilla, CFA, Bondsquawk
In late July, European Central Bank President, Mario Draghi unleashed a tape bomb on the markets by pledging that the Euro will be defended at all-costs. In particular, the ECB signaled that they would institute an unlimited bond buying program from debt-heavy peripherals such as Spain and Italy.
Since then, borrowing costs for peripherals have declined tremendously. Spain’s yield on their 10-Year benchmark bond fell well below the 7% threshold which is viewed by many as the Rubicon for unsustainable debt levels. Since then, details have been sparse on program action which has led to speculation on what to expect at their next meeting, slated for September 7.
Amid facing controversy and criticism from within the region, the ECB is expected to announce a bond buying program through the secondary market (as opposed to the primary where bonds are bought directly from the sovereign which is currently not permitted under the ECB mandate). This of course assumes that the sovereign would agree to ‘conditionality’ which means promises of reigning in their fiscal balances in exchange for support by the central bank.
A bond-buying program would ease financial conditions of a dysfunctional Euro market system which in turn would improve monetary policy transmission according to Goldman Sachs’ Huw Pill. The economist from the Wall Street giant wrote in their latest ‘European Economics Daily’ other reasons for the ECB’s buying-spree initiative.
- Easing private financing conditions through monetary expansion. The quantitative easing (QE) programmes undertaken by the Federal Reserve and the Bank of England have aimed at easing financial conditions. Most narratives have emphasised the role played by portfolio balance effects. By making money-financed purchases of sovereign debt from the market, these central banks have shortened the average duration of private balance sheets. As private investors attempt to rebalance their portfolios in response, they buy longer-dated assets to increase the duration of their holdings, thereby driving up the price of equities and bonds. This leads to lower financing costs for borrowers. Such mechanisms allow monetary policy to ease financing conditions even once the lower bound on nominal interest rates has been reached.
- Financing governments. Central bank purchases of sovereign debt in the primary market constitute direct monetary financing of governments. Given concerns about the inflationary impact of such purchases – amply demonstrated by history, with the Weimar experience weighing heavily on German attitudes – they are prohibited by the Lisbon Treaty (the relevant clause – Art. 123 – is applicable both to the ECB and to other EU central banks, including the Bank of England) and many other central bank laws. Purchases in the secondary market can also support government financing, for example by suppressing sovereign yields. In the limit, secondary market purchases can be functionally equivalent to primary purchases, if an intermediary simply stands between the sovereign issuer and the central bank purchaser to circumvent any prohibition on primary market purchases.
- Reactivating private markets. Finally, central bank purchases can be used to reactivate markets that have seized up on account of information or coordination problems. For example, should a sovereign with a fundamentally sound fiscal position face a market sceptical of its solvency or commitment to the Euro, borrowing rates will rise as a credit and/or convertibility risk premium becomes embedded in government yields. But that rise in yields, by its nature, increases sovereign funding costs and could validate concerns about fiscal sustainability and/or Euro exit. The government may be trapped in a high interest rate / high default risk equilibrium, even though another, more desirable low interest rate / low default risk equilibrium exists. Well-designed interventions by the central bank can shift the market to the more desirable situation. Since the main concern is rolling over outstanding debt at sustainable rates, interventions at the short end of the maturity spectrum may suffice. And – since sovereign markets are integral to the functioning of the broader financial system – such actions can yield significant broader external benefits in terms of improving the functioning of financial markets and institutions.
While the aforementioned program may lower borrowing costs for the peripherals, the fact is that problems lie below the umbrella of sovereigns and within the banking system. This disconnect between the two disrupts the flow of credit to the rest of the economy which in turn leads to contractionary economic activity. Lower economic growth leads to further deterioration of their fiscal balances and escalation of their debt problems.
While necessary, these measures alone are unlikely to be sufficient. Funding problems for peripheral sovereigns undermine their domestic bank systems and hinder credit supply. As we have argued previously, to improve monetary transmission and ensure monetary stimulus reaches its target – notably, the peripheral private sector – additional, more targeted credit easing measures (e.g., further widening of collateral eligibility, lowering of haircuts and purchases of private sector assets) may be required.
Because of this, further action such as providing liquidity where it is needed coupled with further fiscal reform is required in order to quell the crisis. Until then, the situation across the Atlantic should remain unstable and continue to jostle markets going forward as had been the case for the past several years.