Thursday, August 23, 2012

The ECB Firepower

The idea of multiplying the EFSF/ESM firepower by using purchased government bonds as collateral to borrow from the ECB thus proceeding to buy more bonds, and so on, was firmly rejected by Mario Draghi at the press conference of 2 August after the ECB Governing Body meeting.

Draghi said that he was “a little surprised by the amount of attention that [the possibility of an EMS banking licence had] received in recent press coverage, and in public opinion”… “After all, I have said at least twice that the present design of the ESM does not allow this. It is not up to us to issue a banking licence – this is a matter for the governments. What is up to us to decide is whether the ESM – evenwith a banking licence – can actually be a suitable counterparty that is eligible for central bank financing. And I have said at least twice – at a press conference, and on other occasions – that the current design of the ESM does not allow it to be recognised as a suitable counterparty”  (emphasis added).

Moreover, Draghi referred to “a legal opinion of the ECB on this, which was issued way back [on 17] March 2011”. The Press Conference report actually gave the link to that legal opinion.

Specifically, the ECB legal opinion argues that “Article 123 TFEU would not allow the ESM to become a counterparty of the Eurosystem under Article 18 of the Statute of the ESCB [European System of  Central Banks]. On this latter element, the ECB recalls that the monetary financing prohibition in Article 123 TFEU … is one of the basic pillars of the legal architecture of EMU both for reasons of  fiscal discipline of the Member States and in order to preserve the integrity of the single monetary policy as well as the independence  of the ECB and the Eurosystem”.

Article 123 of the Consolidated Treaty on the Functioning of theEuropean Union of 2009 (ex-Article 101 of the earlier consolidated version of 2006) stipulates that:

“1. Overdraft facilities or any other type of credit facility with the European Central Bank or with the central banks of the Member States (hereinafter referred to as ‘national central banks’) in favour of Union institutions, bodies, offices or agencies, central governments, regional, local or other public authorities, other bodies governed by public law, or public undertakings of Member States shall be prohibited, as shall the purchase directly from them by the European Central Bank or national central banks of debt instruments.”

Although: “2. Paragraph 1 shall not apply to publicly owned credit institutions which, in the context of the supply of reserves by central banks, shall be given the same treatment by national central banks and the European Central Bank as private credit institutions.”

The legal merits of the case rest exclusively on the ECB's own interpretation of its own rules, not on a Higher Court or on an “authentic” interpretation. Nevertheless, clearly we must take no for an answer: regardless of the legal position there is no willingness in the ECB Governing Body to transform the ESM into the Lender of Last Resort (to governments) arm of the ECB. Draghi’s rejection of this weapon is compounded by similar declarations by Merkel, Schauble, CDU politicians, the Dutch and the Finns.

What about the ECB acting as an EFSF/ESM agent, within the relatively small EFSF residual budget (about €150bn) and/or - subject to the approval of the German Constitutional Court expected on 12 September - the limited but more substantial ESM (€500bn), with a view to reduce the spread on the bonds of “virtuous” governments?
Here there are more encouraging developments:

1)      On 20 August the Bundesbank Monthly Report confirmed its President’s view that “bond purchases are problematic and lead to risks for stability”. At the same time Jorg Asmussen, the other German representative on the ECB Governing Body, actively and loudly supported “unlimited ECB [government bonds] purchases, for the ECB wants to take out any doubts among market participants about the future of the euro” (, 21 August);

2)      The details on the use of the EFSF/EFM as an anti-spread shield are still under discussion, but the proposal has already been endorsed by Angela Merkel repeatedly over the last month, while the (bad) idea that threshold spread levels would automatically trigger bond purchases has been denied by the ECB;

3)     The credibility of Jens Weidman’s stance has been pre-emptively eroded by the revelation that, back in 1975, the Bundesbank had actually broken its own policy principles and possibly its own statutes by purchasing German government bonds to the equivalent of 1% of its own GDP at the time. (see FT, 7 August, and the excellent piece by Evelyn Harriman of BNP Paribas.

True, the German Central Bank buying German bonds is not the same as the ECB buying Italian and Spanish bonds, but if the ECB bought government bonds of all the EMU member countries, in the same proportions in which they hold ECB shares, re-distribution should not be an issue. As I wrote in my previous post in answer to a comment by a reader:

"Suppose the ECB bought a balanced packet of 100bn of EMU government bonds in the same proportions in which EMU countries hold shares."

"Roughly 30% of ECB shares are held by 10 EU members who are not EMU members (with the UK at 14.5%), the rest is divided among EMU members: Germany 18.9%, France 14.2%, Italy 12.5%, …, Spain 8.3%, Greece 2%, Portugal 1.75%, , Ireland 1.11%, … Malta 0.06%. Therefore the bond packet bought by the ECB would contain 100/70 or roughly 1.43 times each EMU member’s share in ECB capital, eg Spain €11.869 bn."

"Suppose that subsequently Spain defaults and its bonds lose 50% of their value. Germany [as ECB shareholder] loses 0.189*0.5*11.869bn euro, or €1.1216205 bn. An equivalent amount out of the €18.9bn outstanding German debt purchased by the ECB could be cancelled, and so on for all  corresponding losses of other EMU members."

"Non-EMU-member Shareholders would have to be compensated by the ECB for 30% of the loss of value of Spanish bonds, i.e. would have to be paid dividends of 0.30*11.869 bn euro; all ECB outlays to come from ECB profits (including seigniorage if need be, in which case non-EMU members might not be entitled to compensation …)."

"In conclusion, EMU non-members would be compensated for their participation in the cost of Spain’s default with dividends, while EMU members would be compensated by the withdrawal of a corresponding value of their bonds (without prejudice for the present entitlement of non-EMU members to benefit or not to benefit from euro seigniorage)."

So, there is no reason for peripheral (i.e. high spread) eurozone members to panic - yet. Where there is a will there is a way. And financial markets believe in the “Draghi rally”.


Marino said...

Incredible, Così fan tutte? even the Bundesbank! End of a myth.

D. Mario Nuti said...

No reason to be surprised, Marino. This is what all Central Banks are supposed to do. What is incredible is the Bundesbank customary and hypocritical denial of such an elementary and natural aspect of monetary policy, including its own.

Nicola Rubino said...

So, by erasing a partial and proportional value of the EMU member's debt or giving a compensation in terms of dividend to the non EMU members, asymmetric financial shocks in the E.U. could be reduced without any drawback?
And by the way professor, what would be the main problem if the ESM was to refinance governments again using the purchased bonds as collateral? Is the matter mainly related to the idea that, becoming some sort of lender of last resort,the ESM could make the burden of debt even morecumbersome for states who cannot repay it?

D. Mario Nuti said...

Yes, asymmetric financial shocks could be absorbed by correspondingly asymmetric dividend payments - of course within the limits of ECB profits (including seigniorage present value).

And yes, if the ECB were to lend and re-lend to the ESM taking government bonds as collateral - which the ECB claims not to be allowed to do, and anyway is unwilling to do regardless - the EMS would become a de-facto lender of last resort to governments. This would raise the exposure of low-spread member states to default risk of high-spread member states. Again, compensatory mechanism similar to that indicated above would have to and could be devised.

Sid said...

For all your declared opposition to Eurobonds, what you seem to suggest here is an ECB guarantee of Eurozone-wide bonds, i.e. de facto, covert Eurobonds in all but name?

D. Mario Nuti said...

I opposed Eurobonds issued by any EU institution other than the ECB (because they would not have a budgetary cover and therefore count as junk bonds), and bonds subject to joint and several responsibility of all Member States (because they would end up as a liability of richer countries that rightly oppose them).

Eurobonds backed directly or (through the EFSM/ESM) indirectly by the ECB are and have always been fine with me, it is the Germans who drag their feet.

Lanfranco Turci said...

" Where there is a will there is a way". Ok, but how could your hypothetical ECE intervention alleviate significantly the situation of PIIGS?

Presumably the operation would still be subject to a specific request by a country, subject to conditions still not fully specified. If the ECB purchases gained senior creditor status other investors namely banks would suffer and their bonds would lose value.

D. Mario Nuti said...

The conditionality of anti-spread operations, subject to the usual austerity and so-called structural reforms, is the price that Angela Merkel exacts for her support. We still do not know whether all or part of the shield deployment would be conditional. Tough, but better than nothing. And perhaps the firepower of EFSF will be raised after the German Constitutional Court vote on ESM.

It is true that the EMS firepower (through ECB will be 1) limited and 2) not subject to multiplication via pyramid credit operations, but it is still a significant weapon. If only the Germans kept their mouths shut, instead of destroying the optimistic expectations that Draghi manages to generate…

The anti-spread shield should succeed in doing just that, reducing the spread, which by itself should set in motion a virtuous circle: lower spread=lower yield=longer sustainability of debt=even lower spread. And of course its effectiveness would be greatly increased if Mario Monti decided - none too soon - to auction TV frequencies and cut the purchase of F-35 investing the revenue and the savings in growth promotion.

Tom said...

How can you be so optimistic when the CSU's general secretary, Alexander Dobrindt, cals Draghi a "money forgerer", while Jens Weidmann said that ECB purchases government bonds of government bonds were addictive and illegal, prospecting legal action by the Bundesbank?

D. Mario Nuti said...

In a democracy everybody should be free to make a fool of himself, and - I believe - free to insult anybody else, for if the insult is undeserved it will rebound. By the same token, of course, anybody should feel free to call Jens Weidman a malicious fool. Or worse.

Jacob Richter said...

Can someone please enlighten me on today's euro news? Are "Outright Monetary Transactions" eurobonds by another name?

D. Mario Nuti said...

Thank you Jacob for a subtle question (and apologies for my late reply, I have been travelling).

OMT (labelled On My Tab by the British press) are unlimited purchases (i.e. without pre-set limits of quantity and time) of one-to-three-years-residual-maturity bonds, subject to a specific request by a country to the EFSF or the (forthcoming, we hope) EMS, and conditional to a programme of fiscal policy and structural reforms to be monitored by the Troika (EC, ECB and the IMF), with cessation in case of non-compliance.

The answer to your question depends on what happens when the bonds purchased under the scheme actually mature. If the ECB cashes them in and re-buys them this is effectively a form of debt monetization, whatever Draghi says; nobody pays until the re-financing ceases when the country may default, in which case the debt corresponding to those bonds is mutualised, in the sense that the loss involved falls on all ECB shareholders proportionately to their shares (including about 30% non-EMU members like the UK).

The difference with standard Eurobonds, understood as bonds with joint and several responsibility of all EMU members, is that these would naturally be paid by the richer EMU members, whereas OMT losses would be distributed fairly and squarely among shareholders, i.e. they would be truly mutualised.

Jacob Richter said...

No worries. I trust your trip went well?

Damn, that is a very thin dividing line!