16/6/15: Sinn on ECJ's OMT Ruling

Hans Werner Sinn on ECJ ruling concerning OMT:

Not always to agree with, but he's got a point there... Which makes for an interesting debate: is a promise / threat of an action equivalent to an action? In markets - which are based on expectations, as much as physical changes - this just might be so. In which case ECJ shows little ability to understand the market, even if it has great ability to understand the law.

5/6/15: The Fiat of OMT: (almost) three years on...

Remember all the bull about the 'unique' efforts, the 'best in class', the 'prudent policies' that got our bond yields down so dramatically in the past? Well, the view here was and remains that most of the 'normalisation' in bond yields was down not to our internal policies or choices, but to ECB and that our yields declined, largely, in tandem with the Euro area yields (that tandem bit is best explained as the decline in financial fragmentation - the financial gap between the 'periphery' and the 'core'). Here's a handy chart from the BBVA Research plotting the evolution of the latter with some timelines added:

What's even more 'funny' in the above is that what 'worked' for the Euro area was not tangible measures such as LTROs, TLTROs, QE, ELAs etc, but the never-to-be-fulfilled promise of an ultimate backstop - the OMT, which never once was actually used or deployed as a tangible instrument and remains, through today, just that - verbal promise/threat unbacked by anything but the fiat of the markets conviction that no matter how much one needs to, swimming up the powerful waterfall is a bad idea.

The original 'Whatever it takes' moment: https://www.ecb.europa.eu/press/key/date/2012/html/sp120726.en.html

14/1/2015: ECJ Advocate on OMT: We Allow Fudge

Big news today is old news of yesterday:

We can now expect the European Court of Justice to give green light to the ECB's Outright Monetary Transactions (OMT) program as being 'compatible with EU law'. This is based on the interim ruling made today by the ECJ's Advocate General Pedro Cruz Villalon. In the tradition befitting European institution, Villalon said OMT is legal "in principle" under the EU treaty as long as it meets certain criteria.

The restriction is that the ECB refrains from "direct involvement" in fiscal/government financing (which can be satisfied by ECB buying sovereign debt via secondary markets alone). The problem here is that currently secondary markets are already pricing in huge premium on sovereign bonds, with many (including some 'peripheral' countries') bonds trading at negative rates. So ECB will be de facto buying an overpriced paper. The key question, therefore, is who carries two risks:
1) Market risk relating to market pricing (if bonds prices slip over time); and
2) Default risk relating to sovereign decisions (if bonds carry haircuts in the future).

More on these risks later today.

Key point missed by many commentators is that approving OMT does not equate to approving QE. Another key point is that ECB QE is restricted not only by the objections to any purchases of sovereign bonds, but also by the objections to the potential modalities of purchases, such as total quantum, the distribution of purchases across the member states and the nature of risk sharing. The latter problems were not addressed by the ECJ.

All in, there is little new in the ECJ ruling. ECJ traditionally rubber-stamps EU-centric measures. Hence, given the EU support for QE, the decision is hardly a watershed.


Background to ECJ decision:

The key issue to be decided by the ECJ is whether the ECB has, in principle, a right to purchase sovereign bonds outside the immediate monetary policy considerations (e.g. supply of liquidity to the banking sector).

Back in July 2014, Germany’s Constitutional Court criticised the OMT, saying it probably overstepped the boundaries of monetary policy allowed to ECB. However, the German Constitutional Court ruling effectively gave ECJ full consideration of the OMT legality. OMT traces back to July 2012, when ECB President, Mario Draghi, vowed to do “whatever it takes” within the ECB's mandate to save the euro.

The ECJ heard arguments from both sides of the OMT divide in October 2014.


What to expect next:

Technically, German court can revisit the issue after the ECJ ruling, but most likely, a favourable ruling from the ECJ will allow ECB to push forward with some direct QE measures, such as buying government bonds in the markets. The key question, therefore, is whether the quantity of purchases will be sufficient to stimulate the euro area economy or will it fall short of the required. Rumours have it, the ECB is likely to buy up to EUR500 billion worth of sovereign bonds on top of EUR1 trillion programmes to purchase private assets. One sure bet is that the move will be a huge support scheme for bondholders and banks, who will witness significant appreciation in the value of their bond holdings. ECB purchases will do nothing to ease the burden of already excessive government debt levels. And, depending on modalities, the ECB purchases of bonds can have little impact on aggregate demand in the euro area economy.

We can, nonetheless, expect some sort of a bold QE-related announcement at the next ECB meeting.

Key point is that even if ECJ approves OMT legality, we will need to see the details of the QE programme to make any judgement as to its potential effectiveness. The fudge of ECB policy 'innovations' lives on.

5/6/2014: Why ECB might have found a cure that strengthens the disease

Today's announcement by the ECB Governing Council that the Bank will be charging a premium to hold private banks' deposits has the potential to generate two positive effects and one negative, in the short run, as well as another negative in the medium-term. The ECB cut its deposit rate to minus 0.1 percent from zero and reduced its benchmark interest rate to a record-low 0.15 percent.

On the positive side,

1. Lower repo rate can translate, at least partially, into lower rates charged on variable rate legacy loans and new credit extended to households and companies. It will also reduce the cost of borrowing in the interbank markets. This potential, however, is likely to be ameliorated, as in the past rate reductions, by banks raising margins to increase profitability and improve the rate of loans deleveraging. This time around, the ECB introducing negative deposit rates is designed to reinforce the effect of the lending rate reduction. Negative deposit rate means that banks will find it costly to deposit funds with the ECB, in theory pushing more of these deposits out into the interbank lending market. With further reduction in funding costs, banks, in theory can borrow more from each other and lend more into the economies, including at lower cost to the borrowers. Note: in many countries, like Ireland, reduced lending rates will likely mean a re-allocation of cost from tracker loans (linked to ECB headline rate, their costs will fall) to variable rates borrowers (whose costs will rise) washing the entire effect away.
2. Negative rates, via increasing supply of money into the economy, are hoped to drive up prices (reducing the impact of low inflation) and, simultaneously, lower euro valuations in the currency markets (thus stimulating euro area exports and making more expensive euro area imports. The good bit is obvious. The bad bit is that energy costs, costs of related transport services, other necessities that euro area imports in large volumes will have to rise, reducing domestic demand and increasing production costs.

On the negative side,

1. The ECB has spent all bullets it has in terms of lending rate policy. At 0.15 percent, there is very little room left for ECB to manoeuvre and should current policy innovations fail, the ECB will be left with nothing else in its arsenal than untested, dubiously acceptable to some member states, direct QE measures. 
2. But there is a greater problem lurking in the shadows. US Fed Chair, Janet Yellen clearly stated last year that deposits rates near zero (let alone in the negative territory) can trigger a significant disruption in the money markets. If banks withhold any funds from interbank markets, the new added cost of holding cash will have to be absorbed somewhere. If the banks pass this cost onto customers by lowering dramatically deposit rates to households and companies, there can be re-allocation of deposits away from stronger banks (holding cash reserves) to weaker banks (offering higher deposit rates). This will reduce lending by better banks (less deposits) and will not do much for increasing lending proportionally by weaker banks (who will be paying higher cost of funding via deposits). Profit margins can also fall, leading all banks to raise lending costs for existent and new clients. If, however, the banks are not going to pass the cost of ECB deposits onto customers, then profit margins in the banks will shrink by the amount of deposits costs. The result, once again, can be reduced lending and higher credit costs.

On the longer term side, assuming that the ECB measures are successful in increasing liquidity supply in the interbank markets, the measure will achieve the following: stronger banks (with cash on balance sheets) will now be incentivised (by negative rates) to lend more aggressively (and more cheaply) to weaker banks. This, de facto, implies a risk transfer - from lower quality banks to higher quality banks. The result not only perpetuates Europe's sick banking situation, and extends new supports to lenders who should have failed ages ago, but also loads good banks with bad risks exposures. Not a pleasant proposition.

By announcing simultaneously a reduction in the lending rate and the negative deposit rate, the ECB has entered the unchartered territory where negative effects will be counteracting positive effects and the net outcome of the policies is uncertain.

Aware of this, the ECB did something else today: to assure there is significant enough pipeline of liquidity available to all banks, it announced a new round of LTROs - cheap funding for the banks - to the tune of EUR400 billion. The two new LTROs are with a twist - they are 'targeted' to lending against banks lending to businesses and households, excluding housing loans. TLROs will have maturity of around 4 years (September 2018), cannot be used to purchase Government bonds (a major positive, given that funds from the previous LTROs primarily went to fund Government bonds). Banks will be entitled to borrow, initially, 7% of the total volume of their loans to non-financial corporations (NFCs) and households (excluding house loans) as of April 30, 2014. Two TLTROs, totalling around EUR400 billion will be issued - in September and December 2014. The ECB also increased supply of short term money. TLTROs are based on 4 years maturity. Ordinary repo lending will be extended in March 2015-June 2016 period to all banks who will be able to borrow up to 3 times their net lending to euro area NFCs and non-housing loans to households. These loans are quarterly (short-term). Crucially, to enhance liquidity cushion even further, the ECB declared that loan sales, securitisations and write downs will not be counted as a restriction on lending volumes.

Thus, de facto, the ECB issued two new programmes - both aimed to supply sheep money into the system: TLTROs (cost of funds set at MRO rate, plus fixed spread of 10 bps) and traditional quarterly lending. There was a shower of other smaller bits and pieces of policies unveiled, but they all aimed at exactly the same - provide a backstop to liquidity supply in the interbank funding area, should a combination of lower lending rates, negative deposit rates and TLTROs fail to deliver a boost to credit creation in NFCs sector.

Final big-blow policy tool was to announce suspension of sterilisation of SMP programme - I covered this topic here. The problem is that Mario Draghi claimed that non-sterilisation decision was acceptable, since non-sterilisation of SMP does not imply anything about sterilisation of OMT (his really Big Bazooka from 2012). He went on to say that ECB never promised to sterilise OMT in the first place. Alas, ECB did promise exactly that here. Update: WSJ blog confirming exactly this and published well after this note came out is here.

In line with this simple realisation - that non-sterilisation of SMP opens the door to outright funding of sovereigns by the ECB via avoidance of sterilising OMT - German hawks were already out circling Mr Draghi's field.

Germany's Ifo President Hans-Werner Sinn said: "This is a desperate attempt to use even cheaper credit and punitive interest rates on deposits to divert capital flows to southern Europe and stimulate their economies," Sinn said on Thursday in Munich. "It cannot succeed because the economies of southern Europe must first improve their competitiveness through labour market reforms. Long-term investors, in other words savers and life insurance policy holders, will now foot the bill," warned Sinn.

And there we go… lots of new measures, even more expectations from the markets and in the end, Germans are not happy, while Souther Europe is hardly any better off… In the long run - weaker banking sector nearly guaranteed… A cure that makes the disease worse?.. And if one considers that we just increased even further future costs of unwinding ECB's crisis policies, may be the disease has been made incurable altogether?..

Here are a couple of charts showing just how massive this legacy policies problem is (although we will face it in the mid-term future, not tomorrow):

Did Draghi just make the impossible monetary dilemma (here and here) more impossible?

22/5/2014: Paging Super Mario: Cleanup in the German Isle

Remember the OMT - the ballistic missile Super Mario fired in the direction of the markets to calm the hell out of them and dramatically lower the bond yields for the countries saddled with the likes of the FG/LP/Troika coalitions (known colloquially as 'peripherals')?

Well, those pesky Germans never really liked the idea and as we all know (past history is a good indicator) when Germans don't like something, it is for a long... long... long time...

07/03/2014: To sterilise or not to sterilise... ECBs (possible) next dilemma

Yesterday, I was asked by a journalist a question about the possible effects of ECB non-sterilising SMP operations. 

The question was in relation to the measure that has been rumoured as being a part of the ECB’s toolkit under consideration for adoption and it is bound to come up in the next meeting of the GC.

The answer is that we do not know.

Currently, ECB is sterilising around EUR175 billion via weekly operations. Absent such sterilisations, the money will remain within the euro system banks. This is as far as we know. Beyond this point, we can only speculate as to what will happen. 

In normal monetary and balancesheet conditions, banks will lend this money out into the interbank markets, leading to reduced Eonia and, downstream also Euribor, rates. This, in turn, will increase banks willingness to lend to the real economy - businesses and households, but also to purchase government debt. Traditionally, non-sterilised market interventions are seen as an effective tool for increasing money supply in the environment of zero-bound interest rates. And there are good reasons to believe that such a measure would be more effective in raising supply of credit in the euro system than a 25bps cut in the policy rate, as it will likely have a more dramatic effect on Eonia rate and simultaneously flatten the money market curve. Additional benefit of such a measure will be the signal it will send to the markets. Removing requirement to sterilise its SMP, ECB will be signalling that it is open to the traditional QE measures - extending 'whatever it takes' argument from sovereign risk markets (OMT) to the real economy (deflation risks). This too is likely to add liquidity available in the euro system.

However, we are not in a 'normal' monetary and balancesheet environment. Increasing supply of liquidity via non-sterilising SMP can lead to banks substituting away from their normal ECB funding, and as the result, net liquidity supply may not rise by as much as the reduction in sterilisations. 

Two other, longer-term, effects of non-sterilising SMP are: potential loss of credibility and threat to OMT.

By not sterilising SMP, the ECB will signal a major departure from its past commitments, which does not help market confidence in its other commitments, namely the commitment to hold interest rates low over long term horizon. This is a relatively weak argument against non-sterilising of SMP, as all long term monetary policy commitments are only credible as long as underlying fundamentals warrant them. The second point is more salient. ECB committed itself to sterilising not only SMP but also OMT purchases. So far, ECB did not make any OMT purchases, but it already faces stern opposition to OMT from Germany. If ECB signals willingness to break its commitments to sterilisation under SMP, it can send a wrong signal on its commitments to the same under OMT, further putting pressure on ECB to scrap OMT.

Overall, materially, removing requirement to sterilise SMP will, in my view, result in a moderate drop in Eonia and will provide improved supply of credit to the economies that currently do not witness severe credit constraints, such as Germany, where current credit supply conditions are already the most favourable of any period in recent history.

But I doubt that such a measure will have a material impact on peripheral economies due to the general breakdown in the transmission mechanism within the euro area.

Crucially, if ECB opts for non-sterilisation of SMP over the option of lowering policy rates, such a move will not help existent debtors. As the result, non-sterilisation might help where help is least needed and will do little to provide any support for economies with severe corporate and household debt overhang.

Finally, along the longer range expectations, forward-looking agents will be pricing – in the wake of non-sterilisation now – higher uplift in lending rates when monetary policy returns onto normalisation path. In other words, with non-sterilisation today we can expect higher rates in the future, with sharper rises in the rates to long-term trend levels. This too will hurt current borrowers, as lender will be less likely to pass on margins uplifts they will receive if non-sterilisation does deliver reduction in the interbank lending rates.

Note: my view of the lower/reduced effectiveness of non-sterilised interventions is in line with the view held by many researchers and the ECB that we are operating in the environment with broken transmission mechanism. Application of this argument in the OMT case is exemplified here: http://www.cesifo-group.de/DocDL/cesifo1_wp4628.pdf

8/10/2013: German Voters Go For Status Quo... Redux: Sunday Times September 29, 2013

This is an unedited version of my Sunday Times column from September 29, 2013.


By any measure, last Sunday's German elections highlighted a resounding failure of the country electorate to connect with reality. Despite returning a number of historical outcomes, the voters reaffirmed the passive-conservative leadership mandate exercised by Angela Merkel since 2009. As the result, German policies are now likely to drift even farther away from the immediate needs of the euro area periphery, risking a renewal of the euro area crisis and a slowdown in the already less-than ambitious speed of European reforms. None of this is good news for Ireland.

The historical nature of the 2013 German elections is highlighted by the fact that Angela Merkel became the first euro area leader to be reelected as the head of state since the beginning of the Great Recession. And she has done it twice: first some 12 months into the crisis in 2009 and now 5 years from its onset. Ms. Merkel won the highest number of votes for her CDU/CSU party in 23 years. And she became the first German leader since the golden days of Konrad Adenauer back in 1961 to personally dominate the elections, instead of standing in the shadow of her party. Individually, all of these are rare events in modern German history. Taken together, they are probably unprecedented.

But herein lies the problem for all of us living outside Germany. The elections of 2013 have produced a strong mandate for doing nothing new when it comes to either the euro area or the larger Union reforms. The Chancellor re-elect retook the Bundeskanzleramt on a mandate of being a 'safe pair of hands'. The campaign her party waged focused on such important topics as charging foreign drivers for using autobahns. Instead of debating the core issues faced by the EU, and the role of Germany in this mess, voters largely engaged in navel-gazing. Satisfied with their relatively well-performing economy and receding immediate danger to the euro, they endorsed the leadership devoid of ideas, alternative views and aspirations. Not surprisingly, philosopher Jurgen Habermas declared the 2013 general election campaign a "collective failure" of the elites.

This means that the German elections left the core problems of the euro crisis unaddressed, raising the specter of renewed uncertainty about the future of the common currency area. This concern became immediately visible this week.

On Monday, ECB's Mario Draghi rushed to compensate for the policy paralysis signaled out of Germany by stating that the ECB is ready to deploy a new round of quantitative easing in the form of the third Long-Term Refinancing Operations (LTRO3). To remind you, the first two rounds of LTROs were the ECB’s ‘pre-nuclear option’ response to strategic threats to the euro area economy in late 2010-early 2011. The ‘nuclear option’ was the subsequent announcement of the stand-by quantitative easing programme, known as Outright Monetary Transactions (OMT). Mr. Draghi mentioning the prospect of renewing the LTRO scheme suggests that the ECB expects no change in euro area policies in the aftermath of last week’s elections.

Acknowledging this, Draghi also tried to push aside the pesky issue of the Greek Bailout 3.0. And in a direct reflection of the Berlin’s preferences, Draghi also downplayed the possibility of the ESM being licensed to provide financing cover for future bank failures.

Mr Draghi’s precautionary moves were timed perfectly. Following the elections, sovereign yields on all peripheral countries’ bonds rose relative to German bunds. Credit default swaps – insurance contracts underwriting sovereign bonds – also crept up. The markets are not buying the ‘return to status quo’ story as good news. This was contrasted by the domestic news which saw the German economic sentiment, as measured by the CESIfo index of economic conditions rise for the third month in a row. This marks fifteenth consecutive quarter of the CESIfo index reading above historical average. In contrast, euro area economic conditions index has been stuck below its historical average levels for eight quarters in a row through this September.

Since 2009 elections, Chancellor Merkel held back from directly leading the euro area and instead opted repeatedly to wait for an escalation of the crises before responding with un-prepared, often ad hoc and wrong-footed solutions. Best examples of this approach to leadership are the EU's failures in Cyprus and Greece. Both are directly linked to Ms. Merkel’s prevarication in the face of escalating crises. All were driven by swings in domestic public opinion, rather than by any cohesive principles.

For Ireland, this mode of leadership spells lack of progress on key issues.

Gauging German public opinion there is currently zero appetite to shift away from the pre-elections status quo in which the Irish crisis is seen as largely self-induced and peripheral to German interests. This means that Germany is likely to continue supporting Irish debt sustainability rhetorically, while opposing practical resolution of the debt overhang. This week, Ms. Merkel gave another loud endorsement to Irish Government policies during the crisis. As she did so, the Irish Government – usually not known for its skeptical pragmatism – was actively pushing the timeline for banking debts problem resolution out into the later months of 2014. My gut feeling is that we can expect this timeline to stretch beyond 2015. Instead of allowing restructuring of our banking debts, Berlin will nod approvingly to a precautionary line of credit for Ireland via set-aside stand-by facility at the ESM. This credit will be provided on current ESM funding terms, some 1 percent below the cost of IMF funding and with longer maturities. Which is the good news.

In exchange for this token gesture we will be required to strictly adhere to fiscal adjustment targets for 2015. We will be further subjected to a new multi-annual fiscal programme stretching into 2018-2020 to be supervised by the EU Commission. ECB – by proxy, the German government – will be watching from the shadows.

Meanwhile, as Mr. Draghi statement this week indicates, Germany will block ESM from having any powers in dealing with future banking crises. Our retrospective banks debt deal will then have to wait until a new funding facility, most likely administered by the ECB, comes into place. Pencil that for sometime in 2016. Pushing legacy debts incurred by the Exchequer as the result of rescuing our banks into the hands of the ECB is likely to cost us. Frankfurt can, and potentially will, demand something in return for this. One thing the ECB can ask for is accelerated sales of the Central Bank-held Government bonds (the fallout from the Promissory Notes deal done earlier this year).  The ECB already has the power to do so. It also has a direct incentive: the bonds are set against our banks borrowings from the euro system. Of course, this will mean that we will be trading one debt for another, as accelerated sales of bonds will erode the temporary fiscal ‘savings’ achieved by the Promo Notes restructuring.

But the cost of the EU/German ‘assistance’ for Ireland will most likely extend further than bonds sales acceleration and new fiscal targets setting. German political agenda is well-anchored to continued saber-rattling on the need for corporate tax harmonization across the EU. With the 2009-2011 Franco-German tax harmonisation initiative all but dead, the focus in the next two-three years will shift toward advancing the consolidated common corporate tax base (CCCTB) proposals that suit German interests more than any other form of tax coordination. Based on her record to-date, Ms. Merkel is a fan of the CCCTB as are all of her potential coalition partners and the German voters.

German elections are also promising to create less certainty as to the structural reforms in the European Union space. Last Sunday’s results produced strong votes for the anti-euro party, Alternative fuer Deutschland (AfD). The party also did well in the previously held local elections. The new Merkel-led coalition will have to show caution when facing any prospect of further harmonisation and consolidation of power in Brussels.

When it comes to structural reforms, German public prefers for euro area to focus on specific hard fiscal targets and on replicating Germany's own structural reforms of the 1990s. While such reforms can be beneficent to the euro area peripheral states, for Ireland they offer only marginal gains. German reforms of the 1990s have focused on two core policy pillars: increasing flexibility of the labour markets and decreasing the burden of the welfare state. These came at a cost of continued consolidation of German economy around larger enterprises and suppression of domestic demand and household investment.

Ireland today requires some reforms in the social welfare system. But we also need to break up our dominant market players in the domestic sectors and to increase our households’ spending and investment.

In short, in the wake of the German elections, there is preciously little that Ireland can expect in terms of the European support for our recovery. Europe, with German blessing, will most likely lend us a hand to help us out of the 'safe' boat of the Troika programme. Thereafter, swimming in the turbulent waters of the Eurozone crisis will be up to us. Let's hope Budget 2014 provides generously for flotation vests.

BOX-OUT:

Marking the fifth anniversary of the Banking Guarantee of September 2008, there are plenty of stocktaking exercises going around. Yet, for all the ‘Fail’ marks being rightly handed out to the Guarantee, all signs in the streets suggest we have learned next to nothing from our past errors. This week offers at least two such examples. Firstly, the crisis showed that a non-transparent system of monitoring and managing financial risks will result in the connected-few gaming the entire system. This week, Minister Noonan intervened in the process of winding down the IBRC, bending the rules that normally apply to company liquidations. Granting anonymity to the funders of the toxic banks comes as a priority in this country. Unintended consequence of this is that it also perpetuates the cronyist relationship between the financial services and the state – exactly the outcome we should have learned to avoid. Secondly, we know that principles-based regulations require swift, robust and unambiguous enforcement. Also this week, the Central Bank effectively shut the door on any further investigations into Anglo dealings with the regulators that could have arisen from the infamous Anglo Tapes. Five years in, there are zero prosecutions, and scores of closed investigations. To paraphrase Bon Jovi’s famous refrain: the less we learn, the more things stay the same…

22/8/2013: Slow Moving Sovereign Debt Crises: a new MIT Paper

Guido Lorenzoni and Ivan Werning (LW, 2013) new paper "Slow Moving Debt Crises" (June 30, 2013, MIT Department of Economics Working Paper 13-18. http://ssrn.com/abstract=2298813) theoretically links the environment and policies conditions that can lead to self-fulfilling increases in sovereign interest rates.

To do so, the authors use a model of the dynamics of debt and interest rates in a setting where default is driven by insolvency. "Fiscal deficits and surpluses are subject to shocks but influenced by a fiscal policy rule. Whenever possible the government issues debt to meet its current obligations and defaults otherwise."

The result is a model that has multiple equilibria where both "low and high interest rate equilibria may coexist". There are self-fulfilling risks as "higher interest rates, prompted by fears of default, lead to faster debt accumulation, validating default fears. We call such an equilibrium a slow moving crisis, in contrast to rollover crises where investor runs precipitate immediate default." In a sense, Italy, and potentially the rest of the euro area periphery, ex-Ireland, appear to be stuck in this 'slow moving debt crisis'.

In September 2012, commenting on the ECB announcement of OMT, the ECB’s president,
Mario Draghi, clearly linked the on-going sovereign debt crisis in euro area peripheral states to a self-fulfilling crisis: “…we are in a situation now where you have large parts of the Euro Area in what we call a bad equilibrium, namely an equilibrium where you have self-fulfilling expectations. You may have self-fulfilling expectations that generate, that feed upon themselves, and generate adverse, very adverse scenarios. So there is a case for intervening to, in a sense, break these expectations [...]”

According to LW (2013): "If this view is correct, a credible announcement is all it takes to rule out bad equilibria, no bond purchases need to be carried out. To date, this is exactly how it seems to have played out."

In the LW (2013) model, "the government faces a fluctuating path of fiscal surpluses or deficits, that are affected by shocks and the current debt level. Each period, it attempts to meet these obligations by visiting a credit market, issuing bonds to a large group of risk-neutral investors. The capacity to borrow is limited endogenously by the prospect of future repayment and default occurs when a government’s need for funds exceeds this borrowing capacity. In equilibrium, bond prices incorporate the probability of default."

Bonds can be issued as short-term and long-term. "In the case of short-term debt", LW (2013) show that "the equilibrium bond price function (mapping the state
of the economy into bond prices) is uniquely determined."

The main point, however, is that uniqueness of he price function "does not imply that the equilibrium is unique. Multiplicity arises from what we call a Laffer curve effect: revenue from a bond auction is non-monotone in the amount of bonds issued. If the borrower targets a given level of revenue, then there are multiple bond prices consistent with an equilibrium."

"With long-term bonds the price function is no longer uniquely determined, because a
bad equilibrium with lower bond prices in the future now feeds back into current bond
prices. In addition, the existence of a good and bad equilibrium may be temporary. For
example, if we follow the bad equilibrium path for a sufficiently long period of time,
the debt level may reach a level for which there exists a unique continuation equilibrium with high interest rates; the bad equilibrium may set in."

This is important to the current case, as it links directly high level debt starting position to the bad equilibrium outcome without the need to reference investors' withdrawal from the funding market. This is the core difference to the traditional crises and LW (2013) call this a 'slow moving debt crisis' "to capture the fact
that it develops over time through the accumulation of debt" as distinguished "from liquidity or rollover debt crises". The 'liquidity crisis' occurs when "current investors, …pull out of the market entirely, leading to a failed bond auction; complete lack of credit then triggers default, analogous to depositors running on banks".

LW (2013) model "can be used to identify a “safe” region of parameters, for which
the equilibrium is unique. In particular, the safe region corresponds to a low initial debt level and to high responsiveness of the surplus to debt in the fiscal policy rule."

Very interesting conclusion from the LW (2013) paper is that "with long term debt, a slow moving crisis, by its very nature is due to a breakdown in the coordination of investors at different dates. As a result, it cannot be averted by coordinating investors meeting in a given market at a certain moment of time. If, instead, the borrower could commit to a certain bond issuance, this would eliminate the multiplicity problem." The commitment that ends such a crisis, in theory, implies commitment to specific steady levels of borrowing - a deficit path - while maintaining certain debt bounds forward. In contrast to mainstream literature, LW (2013) "assume that the borrower cannot commit to a certain bond issuance, because it cannot adjust its spending needs. Thus, it will issue the bonds needed to finance its obligations." The reason for this assumption is that while the borrowers "can control the amount of bonds issued… during any given market transaction or offer", in the long run, the actual amounts raised in the markets will not be fully predictable. Per LW (2013): "consider a borrower showing up to market with some given amount of bonds to sell. If the price turns out to be lower than expected the borrower may quickly return to offer additional bonds for sale to make up the difference in funding [and thus] …the overall size of the bond issuance remains endogenous to the bond price."

LW (2013) conclude that "it seems difficult to dismiss the concern that a country may find itself in a self-fulfilling “bad equilibrium” with high interest rates. In our model, bad equilibria are not driven by the fear of a sudden rollover crisis, as commonly modeled in the literature following Giavazzi and Pagano (1989), Alesina et al. (1992) and Cole and Kehoe (1996) and others. Thus, the problems these “bad equilibria” present are not resolved by attempts to rule out such investor runs. Instead, high interest rates can be self fulfilling because they imply a slow but perverse debt dynamic. Our results highlight the importance of fiscal policy rules and debt maturity in determining whether the economy is safe from the threat of these slow moving crises."

29/10/2012: More on CDS markets woes

Few days ago I mentioned I stopped watching CDS on a daily basis... and here is more on the same: link.

Well done, Europe. Nothing like sledgehammering the markets. Step next: shove loads of sovereign debts into ESM, OMT and on the 'emergency' lending lines at ECB and NCBs. That'll teach the markets how to price risk.

28/10/2012: BNP note on Spanish Bonds risks

A neat summery from BNP on (1) current bond ratings, and (2) links between ratings and eligibility for inclusion in bond indices:

And a few words on the importance of Spanish ratings risks to ESM/OMT etc:

"As has been demonstrated throughout the EU debt crisis, credit ratings can have a material impact on sovereign bond markets. ...However, not all downgrades have the same effect on bond yields. More specifically, the loss of an AAA rating (S&P on France and Austria, for example) and, more importantly, the loss of investment-grade status (Greece, Portugal) matter more than other downgrades and may have dire consequences for sovereign bonds, because of the significance of those two ratings levels as critical thresholds for investors."

"The downgrade to sub-investment grade, in particular, is linked to the eligibility criteria for various global bond indices, i.e. the minimum rating required for a sovereign bond to be included in an index. Fund managers tend to track the performance of major bond indices and, as a result, when a country’s sovereign bonds drop out of an index due to ratings ineligibility, investors have to adjust their portfolios and offload the country’s bonds. So, any downgrades to sub-investment grade could lead to massive selling flows and have a huge impact on the bond yields of the country in question. More than that, quite often, markets tend to front-run the ratings agencies and start to offload the bonds of the country they suspect may be downgraded to sub-investment grade in the near-term future."


"... Currently, Spanish ratings are getting extremely close to those same [as Portugal in 2011 downgrade case] eligibility thresholds. In general, BBB- is the critical limit for bond index eligibility, but different indices have different rules on calculating a single rating for each country (they can use, say, the average, middle, best of all, or specific ratings). For Spain, currently rated BBB-/Baa3/BBB, any trio of one-notch downgrades is going to push the average rating below the eligibility threshold."

"Credit ratings are important not only with respect to eligibility for the major bond indices, but also in calculating the haircut the ECB applies to collateral posted by European banks. According to the ECB’s graduated haircut schedule, an extra 5% haircut is applied to ratings in the BBB+/BBB/BBB- range (the ECB uses the best rating of S&P, Moody’s, Fitch and DBRS). This extra 5% haircut applies only to category 1 assets, which include government bonds. For other assets, like bank, corporate and agency debt, this extra haircut can reach up to 23.5%, creating severe additional collateral requirements for banks."

"This is particularly important for Spanish banks, which tend to absorb around EUR 400bn of liquidity from ECB’s open market operations. The ECB recently announced that it is suspending the application of the minimum credit-rating threshold to its collateral eligibility requirements for the purposes of the Eurosystem’s credit operations for marketable debt securities issued or guaranteed by the central government of countries that are eligible for OMTs or are under an EU-IMF programme and comply with the associated conditions. However, this does not affect the application of the previously mentioned graduated haircut approach."

"So, focusing on Spain, a one-notch downgrade by DBRS would mean that marketable securities issued by Spain would fall into the higher haircut range and Spanish banks would have to post additional collateral with the ECB. A trio of one-notch downgrades by S&P, Moody’s and Fitch would push the Spanish average rating below BBB- and Spanish bonds out of those bond indices that use the average rating as the threshold for eligibility. For those bond indices that use the middle rating of S&P/Moody’s/Fitch (or the better of the first two), a one notch downgrade by each of Moody’s and S&P would be enough to push the single rating below the eligibility threshold, too. Because of this, any upcoming developments in relation to (1) direct bank recapitalisation by the ESM, (2) a Spanish request for a precautionary programme, (3) economic and social developments in Spain and (4) funding rates are going to be critical, as they could prompt further downgrades, with severe implications for the Spanish bond market."

"If any of these downgrade combinations takes place before Spain has made an official request for a programme, we believe a request would, in effect, become inevitable. At the same time, if Spain asked for a programme tomorrow, this would not necessarily mean that any further downgrades would be off the cards. Almost all of the ratings agencies have said that they will have to assess whether ESM intervention is likely to become a complement to or a substitute for market access. If it turns out to be the latter, this would be in line with a downgrade to the sub-investment-grade category."

"At this point, we should mention that if Spanish bonds are removed from the global bond indices, this could have an impact on Italian bonds as well. The reason is that some investors may have replaced their Spanish bond holdings with an Italian bond proxy in order to benefit from better liquidity and protect themselves from panic selling, should Spain be downgraded further. As a result, if Spanish bonds’ drop out of various indices, these investors could suddenly find themselves overweight Italy versus the index, so they would have to sell some of their Italian bonds to re-adjust their weightings and track the index."

"We saw this kind of move when Portugal was downgraded to junk by Moody’s in July 2011 (taking into account that this was not completely expected by the markets and PGB liquidity had already dried up). In the five days after Portugal’s downgrade, 5y Italian and Spanish yields jumped by 95bp and 65bp, respectively."

Nasty prospect, albeit the risks are diminishing, in the short run, imo.

28/10/2012: ECB and technocratic decay?

Some interesting comments from BNP on ECB and Mr Draghi's tenure to-date. The note is linked here.  But some quotes are enlightening [comments are my onw]:

"While the ECB justifies the OMT as being to improve the functioning of the monetary system, the fact it has done nothing to help the monetary system in Ireland or Portugal suggests the scheme is about fiscal financing." [I fully agree]

"The balance-sheet implications of buying in the secondary market are the same as if bonds had been bought in the primary market. Mr Draghi’s adherence to the spirit of the Treaty is in question. We support his flexibility, however." [In the short run - yes, Draghi's flexibility is a necessary compromise. Alas, in the long run it is of questionable virtue. Hence, as I remarked ages ago, it's not the measures the ECB unrolls in the crisis that worry me, but the impossibility of unwinding them without wrecking havoc on the economy.]

"...Mr Draghi did [cut rates] in November and December [2011], taking rates back to where they started the year before the two misguided mid-2011 hikes. Mr Draghi cut rates again in July 2012, not only taking the refi rate below the 1% barrier (to 75bp), but also cutting the deposit rate to zero, apparently in an attempt to reinvigorate the interbank market (so far, fruitlessly). Mr Draghi should be praised for cutting rates and for overcoming the 1% barrier, in our view." [I agree.]

"However, he seems to be reluctant to take the deposit rate below zero, which looks timid. Moreover, he has failed to stimulate private credit supply. The LTRO has facilitated the expansion of credit to governments, but to some extent, this has crowded out private-sector credit, where growth is now down 0.8% y/y (-0.4% adjusted for sales and securitisation). The line that this is due to weakness in credit demand is a feeble excuse for the ECB failing to do enough to stimulate supply or to circumvent the lack of credit supply, for example, through credit easing. This has been the major failure of Mr Draghi’s tenure." [I am not so sure on BNP rejecting the idea of weak demand. Most likely, both weak supply and demand are reinforcing each other. More on this once we have our paper on SMEs access to credit published in working paper format, so stay tuned].

And the last blast, the potent one: "If central bankers don’t want politicians to mess with central banking, central bankers would be wise not to mess with politics. Mr Draghi was intimately involved in Italian politics and the demise of former Prime Minister Silvio Berlusconi’s tenure in the summer of 2011. More recently, his plans for the OMT were reportedly shared with the German chancellor’s office well in advance. The ECB is a very political animal under Mr Draghi. As the only institution with pan-eurozone power, a prominent role for the ECB in crisis resolution and a strong link to politics
may be unavoidable, and even desirable. But ultimately, such links may return to haunt it." [Yep, I agree. Mr Draghi's competence in office comes with a typical European price tag - get a technocrat and surrender checks and balances. This both signifies to the sickness at the heart of Europe (technocracy displacing democracy) and the inability of the 'patient' to develop institutional path for dealing with this sickness (with EZ potentially/arguably facing either a collapse in the hands of democracy or decay in the hands of technocracy).]

13/9/2012: Buying more time for the Euro

My recent analysis of the ECB announcement of the OMT in The Globe & Mail

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