Thursday, September 6, 2012

6/9/2012: ECB's OMT: Negatives slightly outweigh Positives

Here's the distilled version of what ECB did and did not do today. A usual caveat applies - the markets can agree or disagree with this economist's view and other economists will  disagree with this economist's view.

ECB President Mario Draghi attempted to do the tight rope walking and keep markets guessing as to what ECB will do in the end in sovereign debt markets while not deflating the expectations bubble he created with his earlier pronouncements.  That he seemingly delivered on. The core potentialities of his announcements (I stress - potentialities, as in none of these are set in stone and all are subject to huge set of uncertainties) were outlined by me here. These remain functional.

In terms of today's announcement, the overall sentiment is that of a small net negative, driven by the three major negatives: conditionality (linked to the OMT), the three remaining uncertainties (design, deployment and delivery - to be explained below), and sterilization; only partially off-set by positives: unlimited programme (in theory), pari passu purchasing (risk-sharing), maturity focus and collateral easing.

Now on to details:

Positives from the OMT announcement:

  • Lack of pre-set limits on bonds purchases is a positive, although, of course, there is always a physical limit and there is also an economic bound to be imposed implicitly by sterilization operations (remember, under sterilization, in effect the ECB will be pumping liquidity into sovereign markets, while pumping same liquidity out of the already distressed private markets). The 'unlimited' purchasing will be severely tested by Italy and Spain (when/if these countries swallow the conditionality costs and join the programme, as Spanish and Italian bonds redemptions for suited horizon (2013-2015) will be in the region of €530 billion or more than 1/2 of the LTROs 1 & 2 combined.
  • ECB accepted the premise of official lender participation in future restructurings, by committing to pari passu treatment of its OMT purchases. Sadly for Greece, this comes too late to save some €100 billion or so that could have been restructured under the SMP in the beginning of this year, but is now off-limits. In fact the SMP purchases remain senior. It is unclear if the ECB will mop up SMP holdings into OMT or how these will be unwound. If they are to be held to maturity, they will remain a risk drag for private holders and we have a two-tiered seniority market on our hands.
  • Maturity focus remains on 1-3 year horizon, which comfortably works with the economic logic I outlined in the note linked above. However, one issue is that the ECB will hold OMT purchases to maturity, implying a potential redemption cliff for the sovereigns engaged in OMT that can be exacerbated, from the ECB point of view by coincident maturity of the LTROs. 
  • Easing of the collateral, and in particular allowance for FX-denominated collateral is similar to what ECB undertook in 2008-2010 period transactions and should provide a wider range support.

Negatives from the OMT announcement:

  • Very strong conditionality rhetoric from the ECB, with access to the OMT only via EFSF/ESM and with full macroeconomic conditionality in the form of compliance with the Enhanced Conditions Credit Line (ECCL). IMF oversight involvement is sought, making the OMT a sort of Troika-junior engagement for any country involved. This dramatically reduces the likelihood of any country going into OMT and in particular is a net negative for the countries that might benefit from the OMT when in the process of exiting the current Troika arrangements, such as Ireland and Portugal. In fact, the two countries can only qualify for OMT as they exit Troika deal and this will de facto mean that exiting the Troika deal will re-enter them into another Troika-light deal with OMT - a political no-go territory. It is also a major barrier for Spain and Italy.
  • The OMT is a time-buying exercise, in so far as it can only allow the Governments some time (1-2 years) to put in place structural reforms. It does not resolve the crisis itself. The problem is that the Government now have to 
    • design the right set of reforms (which is not as straight forward as one can imagine - of the 3 current Troika-programme run countries, only Ireland and Portugal have so far managed to design some sustainable reforms and not all so far, after a number of years of attempting such designs pre-Troika and during the Troika reign);
    • deploy the designed reforms (which is a tough process that has to be sustained over time and across political elections. In the sub set of three states currently in Troika programmes, again, only two have managed to partially achieve this, and again, with varying degree of success); and
    • the deployed reforms must deliver desired outcomes (subject to heavy set of risks and uncertainties: of the three participant states, none have so far managed to deliver desired outcomes on reforms packages, especially when it comes to achieving economic recovery).
  • The OMT will rely on sterilization of monetary supply flows into sovereign bond markets, which means that in order to buy government bonds, the ECB will have to somehow remove liquidity out of the euro system. This can only be achieved by reducing liquidity supply to the real economy and/or financial sector. This, in turn, makes OMT hardly accommodative of private sector growth and can derail the 'delivery' bit in the OMT's DDD challenge outlined above.
  • Other negatives worth keeping in mind are: 
    • No numerical targets for yields and no way of assessing these ex ante as bonds purchases will be disclosed only on a weekly basis
    • No change to collateral eligibility for non-government bonds (other than for government-guaranteed bonds), meaning OMT will have no easing effect on liquidity supply in financial sector.
    • Excessive optimism on ECB behalf, with Draghi announcing that the OMT will be a "fully effective backstop that [will] remove tailrisks from the euro area". As I noted earlier, the biggest 'Black Swans' arise when policymakers start believing in non-existence of 'Black Swans'

Update: And here's a map of Draghi's comments on OMT announcement (via Prof Brian M Lucey):
Lets take a note: word 'growth; is the most prominent operative term used and yet, nothing within OMT is about growth. In fact, the policy rate remains unchanged, hence no pro-growth move in policy dimension. The logic of growth-OMT link is a tenuous one at best, and contradictory to the OMT operational objectives. Here's why. OMT - if successful - is supposed to ease the cost of Government's transition to fiscal austerity. It is to be sterilized. Hence, OMT is neither a fiscal nor a monetary tool for sustaining or generating any growth. Other key words to note relate to 'financial' and 'risks' - I commented above on the perverse effect on financial system the OMT is likely have. I have also commented above on the bizarre discounting of risks remaining within the system once OMT is up and running.

Note: I will be working on this post throughout the evening, so stay tuned for additional comments

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