September 10, 2012

ECB President Draghi pretty much fulfilled market expectations when presenting the details of the new SMP, which is now called OMT (outright monetary transactions). The programme’s aim is “to safeguard an appropriate monetary policy transmission and the singleness of the monetary policy”. The sterilized, potentially unlimited, purchases will focus on the shorter end of the yield curve and are conditional on a EFSF/ESM programme or a precautionary programme, with both requiring a MoU. In contrast to the SMP the ECB will not have preferred creditor status.

As expected, the markets love it: equity markets rallied and the peripheral spreads narrowed further, since the ECB – at least for the time being – has offered a put option with regard to a further escalation of the euro crisis. The ECB is walking a tightrope with regard to Article 123 prohibiting monetary financing of government deficits – the most important of the Bundesbank’s objections. We are more concerned about some time inconsistencies and the incentive structure inherent in the ECB's approach. 1) Troika reports (or more likely Duo reports, since IMF involvement will only be sought for the design and monitoring) will become ultra-important since they could potentially result in the ending of support from both the EFSF and the ECB. This probably implies relatively soft MoU conditions. The de facto link between EFSF and ECB support will make it more difficult for one of them to say “No”, since this would risk a massive financial crisis and may ultimately lead to a country being forced to exit the euro. 2) Without preferred creditor status a country’s exit would imply substantial write-offs for the ECB (and the EFSF/ESM). 3) Of course, countries have an incentive to tap the ECB-supported shorter end of the curve, thereby increasing the impact of monetary policy changes on fiscal deficits, posing a future risk for the independence of monetary policy. 4) The ECB's assertion that current spreads incorporate substantial convertibility risk premia is, though true in principle, difficult as an argument, as quantifying them is impossible and opens the door to arbitrary decisions. The fact that financing costs for Ireland (and Portugal) have started declining also shows that the markets may well differentiate between risks appropriately. The ECB is now on a slippery slope from which it may have difficulty extricating itself, especially if the ECB balance sheet swells substantially due to OMT.