ECB bond purchases won’t really help
August 8, 2011 7 Comments
I have discovered a new leading indicator for when the eurozone is going to go into full meltdown mode: my holidays. The good news is I’ve just returned from a holiday that spanned the second half of last week. The bad news is I’m only back for a few hours before flying off again for a whole week. This does not bode well for the euro crisis, but neither does any recent policy making at the EU level. This includes the ECB’s announcement on Sunday that it will intervene actively in the markets through its Securities Markets Programme (SMP), indicating it will purchase significant amounts of Italian and Spanish government debt. This move alone is very unlikely to offer lasting reprieve in the euro crisis.
The ECB let its SMP remain dormant for 18 consecutive weeks before finally reviving it last week in response to intense market pressure on Spain and Italy. Both of these countries saw their government bond yields rise to record highs last week, but the ECB did not reactivate its SMP to purchase Spanish or Italian debt. Instead, the central bank bought Portuguese and Irish debt, and the markets were duly unimpressed.
There are three main arguments why the ECB now stepping in to purchase Spanish and Italian debt might help, but I doubt the effects will be long-lasting. First, the ECB claims to be using intervention in the secondary markets as a carrot to encourage countries to take action to rein in their fiscal dynamics. This is reportedly why the ECB purchased Portuguese and Irish debt last week. On Friday, Italian prime minister Berlusconi announced a series of reforms to show that Italy, like Portugal and Ireland, is serious about getting ahead of its debt problem. Italy will now balance its budget by 2013 (previously 2014) and will push through a number of welfare and labour market reforms. Markets may be temporarily relieved by Italy’s resolve, but this is unlikely to last. Italy already has a primary surplus, so reining in the budget deficit should not necessarily be at the top of Italy’s priority list. Furthermore, the details on the reforms to be implemented are extremely thin and will still need to be hashed out over the remainder of the summer. There is consequently significant room for backsliding.
The second argument is that the ECB’s intervention to purchase Spanish and Italian debt indicates that the central bank stands fully behind the euro project. This is unconvincing for many reasons. If the ECB’s priority were really to backstop the peripheral countries, it would have purchased Spanish and Italian debt last week as those countries’ bond yields hit new record highs on a daily basis. The ECB might also have refrained from raising interest rates in the first half of this year given the potential negative implications for mortgage defaults and borrowing costs in the peripheral countries.
The third argument for why ECB intervention might help is perhaps the most convincing one. According to some analysts, if the ECB purchases significant amounts of Spanish and Italian debt, then borrowing costs for those two countries will fall and the markets will automatically regain confidence in them. The ECB would effectively prevent concerns about bailouts or defaults in Spain and Italy from becoming a self-fulfilling prophecy. There are two main problems with this line of thinking. First, the sheer size of Spain and Italy’s public debt burdens means that the ECB would have to step in with its guns fully loaded to make any significant difference in either country’s borrowing costs. At the end of 2010, Greece, Ireland and Portugal together held around €637bn in public debt. This was still less than Spain’s public debt burden (€639bn at the end of last year) and was a small fraction of Italy’s (€1.8trn, the third largest debt stock in the world behind the US and Japan). It is unclear whether the ECB is really willing to accept such a significant amount of peripheral euro area debt on its own balance sheet given the risks involved.
More importantly, even if the ECB is willing to take on huge amounts of peripheral debt, this is not a medium- to long-term solution. On Sunday evening, German chancellor Angela Merkel and French president Nicholas Sarkozy issued a joint statement indicating that they hope the ECB will step in to calm the markets as a stop gap until euro area parliaments pass the agreed changes to the EFSF by the end of September, allowing the EFSF to buy bonds in the secondary markets. While euro area leaders agreed to expand the scope of the EFSF at the EU summit in July, they did not agree to expand the size of it. With a lending ceiling of €440bn and three EU/IMF bailout programmes already in place (€85bn for Ireland, €78bn for Portugal and €34bn in EU/IMF loans as part of the second Greek bailout), the EFSF will have little more than €250bn left to lend. This is woefully insufficient. Until the EFSF’s lending ceiling is either raised significantly or abolished altogether, investors will continue to put pressure on Spain and Italy, regardless of the ECB’s intervention via the SMP.