As widely expected Draghi yesterday outlined the framework by which the European Central Bank (ECB) will make purchases of Euro-zone sovereign bonds in the secondary market. The new programme to be known as “Outright Monetary Transactions” (OMT) will replace the previous Securities Markets Programme (SMP).
Under the SMP the ECB purchased €211bn of peripheral sovereign bonds. Purchases were “sterilised” by the ECB issuing short-term bonds to commercial banks. No new money was created as the ECB funded every sovereign bond purchased with excess commercial bank deposits. When Greek debt was restructured last year the ECB insisted that it would not take losses on its €60bn (estimated) of Greek debt purchased through the SMP. This meant that private Greek creditors ended up taking a bigger write-down on their debt than if the ECB had done nothing. As long as the ECB continued to insist on seniority for its debt, further purchases of sovereign bonds were considered counter-productive given that they increased the default risk for remaining private investors. Although the SMP was never officially de-activated (until now) since Draghi took over at the ECB last year no further bond purchases have been made.
The key difference between the old SMP and the new OMT is the commitment from the ECB for bonds bought by the ECB to rank pari passu with private creditors in the event of a restructuring. Ignoring issues around how the ECB would fund any losses this is a significant concession and should ceteris paribus boost the confidence of private investors in peripheral sovereign bond markets. The ECB have also stated that their bond purchases will have “no ex ante quantitative limits”, which seems to have wrongly been universally interpreted as an “unlimited” commitment of firepower. Bond purchases will continue to be “sterilised” (and are therefore technically not QE) and will in fact be limited by the availability of excess commercial bank liquidity ready to fund ECB paper (as with the SMP). In fact other than the significant concession on “seniority” the new OMT looks a lot like the old SMP.
Given the speculation over the last month about the content of Draghi’s new plan the “conditionality” framework is in our view slightly stricter than anticipated. Only countries that have entered into a EFSF/ESM programme of further austerity reforms in return for primary bond market purchases will qualify. The IMF will also be required to oversee country reform programmes. Intervention will apparently be withdrawn should governments not comply with agreed austerity programmes. It remains to be seen whether the Spanish government will be willing to ask for economic assistance given the likelihood that this will also bring with it further austerity and in the short term perhaps a deeper recession.
Ultimately even if countries agree to requesting assistance, the OMT can only address the issue of liquidity rather than solvency. Through the OMT no Euro-zone country should now run out of money (assuming there is enough excess banking liquidity to fund ECB purchases), but the path back to solvency will still be dependent on economic growth and inflation. From an equity investor’s point of view the “black swan” event of a major European economy leaving the Euro has diminished which is positive for the asset class. Whether the recent market leadership of the most marginal sub-asset class of domestic peripheral assets and Euro-zone banks can be sustained is more questionable.
Founding Partner & Fund Manager
September 7th, 2012