- The ECB has delivered what markets were expecting of them, Outright Monetary Transactions (OMT),a forward-looking constructive response to the growing debt crisis
- The OMT has unlimited purchasing power and will work in tandem with the ESM to bring yields down for eligible members in both the primary and secondary market respectively
- Strict conditionality imposed on applicants will ensure no slippage of standards when it comes to agreeing new measures and implementation of reforms for those seeking OMT
- ECB's chosen tenure of bonds sees it target the short maturity segment, a shrewd calculation which both limits its risk and pressures governments to keep up with reforms
- Pari Passu (equal footing) with private sector investors will rekindle interest from the private sector into the periphery's bonds thereby causing yields to fall as demand increases
- Sterilisation of OMT purchases will not result in monetary printing, but does not detract from Draghi's game plan
- Relaxed collateral eligibility for OMThas the potential to break the vicious reinforcing cycle between sovereign downgrades and weakened banks that require recapitalisations
- The ball is firmly in the politicians court, with the ECB taking monetary policy almost as far as it can go (save for a few interest rate cuts) without resorting to monetary printing
- We maintain Europe at a 3.0 Star - "Attractive" rating
On 6 September 2012, the ECB policy meeting delivered what markets were expecting, with ECB President Mario Draghi unveiling a new program dubbed Outright Monetary Transactions (OMT), in an effort to stem the rise in bond yields of the Eurozone’s periphery. While many details were purposefully omitted, the skeletal framework of OMT has revealed sufficient information for us to analyse and highlight the latest (and thus far most credible) response to the Eurozone sovereign debt crisis which seeks to be a “fully effectively backstop to avoid destructive scenarios”.
Important fact #1: Unlimited Purchasing Power + ESM Support
The ECB has committed that the OMT will have “no ex ante quantitative limits”, or in simple English, the latest program by the ECB will have unlimited firepower upon operation. Unlike its predecessor, the Securities Market Program (SMP) which was explicitly “finite’’, the OMT has no limits, and is projected to run in-tandem with Europe’s permanent bailout mechanism, the European Stability Mechanism (ESM) which is expected to purchase bonds on the primary market of applicants who subject themselves to its programmes. While the ESM will purchase bonds on the primary market, the OMT is designed to act on the secondary market as the ECB is not allowed to purchase government debt on the primary market due to it being akin to the financing of sovereigns, from which it is prohibited from doing.
The explicit mention of the program being unlimited in size and length of operation, should deter speculators from betting against the ECB and provides Draghi with an extremely potent tool with which to manage the expectations of the market on-top of the ESM whose capacity stands at EUR 450 billion. With actions expected to be two-pronged, by politicians keeping up with reforms and security purchases on both the primary and secondary markets (ESM and OMT respectively), it appears Eurozone leaders and policy makers could finally have a potential hold on the debt crisis.
As compared against the SMP (which is due to be terminated), the OMT is leaps and bounds above its predecessor for all purposes and intents, both in terms of its ability to suppress yields, as well as in its willingness to intervene. The striking contrast between the SMP and OMT are a reflection of the differences in leadership between former ECB President Jean-Claude Trichet and current incumbent, Mario Draghi.
Important fact #2: Strict COnditionality & Short Tenure oF Bonds
The attachment of strict conditions in order to be eligible for OMT has eased concerns amongst many market analysts who feared that the latest program would allow governments to let-up on painful but necessary reforms to fix their economies.
With a prerequisite being the seeking and obtainment of a programme from either the European Financial Stability Facility (EFSF), the precursor to the ESM, or from the ESM itself, macroeconomic adjustment programmes (structural reforms, austere measures and fiscal discipline) or precautionary programmes (a less severe programme which will be negotiated directly with the European Commission and the ECB) must be in place is the non-negotiable condition for seekers of the ECB’s assistance. Thus, the likes of Italy and Spain will have to first approach the ESM and enter into a programme before the ECB even considers extending assistance to them. As for those currently in a program (e.g. Greece, Portugal), they too will be eligible to benefit from OMT upon their return to debt capital markets.
While the offer to assist worthy governments who seek to help themselves stands, the ECB clearly has the right to “terminate...when there is non-compliance” with the programmes, and “will decide on the start, continuation and suspension of Outright Monetary Transactions in full discretion and acting in accordance with its monetary policy update.”
Upon meeting the prerequisites, the ECB will have full discretion as to the size and length of intervention on the secondary market, while the OMT will be “focused on the shorter part of the yield curve... with a maturity of between one and three years”.
While assistance is clearly on the table, it is clear that the ECB has shifted the onus back to politicians to keep up with the reforms needed to get their respective countries back on track following historical policy missteps, and that assistance will only be awarded on a very short leash while politicians are still held close enough to the fire to ensure reforms continue to be implemented.
We note that the precautionary programme option is effectively a backdoor for Italian and Spanish politicians to seek and receive aid without subjecting themselves to the harsh austerity measures and tight leash Greece has had to bitterly swallow, something which appears to have been designed to make the terms more palatable for the 3rd and 4th largest economies in the Eurozone in hope that they do apply to the ESM.
The focus of the ECB on the shorter end of the curve is a shrewd move. By focusing on effectively short duration bonds, the ECB sees to it that the countries seeking assistance continue to manage to receive short term funding, while ensuring long term structural reforms are being implemented and targets as agreed upon are adhered to. With the ability to terminate the programme for respective countries “once their objectives are achieved or when there non-compliance”, the focus on short duration bonds will also see the ECB manage its balance sheet risk appropriately, as it will have a relatively short holding time period of the bonds on top of full discretionary control of the conditions with which it bases its “thorough assessment”.
As for governments who seek to outsmart the ECB and begin to issue huge amounts of short term debt to take advantage of OMT, we note that Mario Draghi has warned and pre-empted governments who think they can shorten their debt maturity profile by stating that the ECB will remain vigilant against such actions.
Important fact #3: EqualTreatment, Full Disclosure & Sterilisation, Collateral Eligibility
All OMT purchases will see the ECB accept the same (pari passu) treatment as private or other creditors, while values of purchases and amount of holdings will be published on a weekly basis. On a monthly basis, the average duration of OMT holdings will be published, including a breakdown by country provided to markets.
Additional liquidity created by OMT purchases will be sterilised by monetary operations, while countries eligible for OMT will see a suspension of the minimum credit rating threshold in the collateral eligibility requirements for securities that are guaranteed by governments.
The acceptance of an equal footing between the OMT and private investors should see the latter return to the bond markets of the periphery’s countries which meet the prerequisites mandated by the ECB. As compared to the previous restructuring of Greek debt which saw private investors shoulder almost all of the losses, should there be another round of restructuring of the debt of countries that fall under the OMT, both ECB and private investors will now shoulder the losses together. With the above, it is widely expected that private investors’ (particularly non-domestic) appetite for the periphery’s debt will return and help play a key part in driving down yields to more sustainable levels.
The full and complete transparency granted by the disclosures will serve to keep markets confidence in and awareness of the OMT’s actions. In addition, it will also serve to let markets know which countries are in the ‘protection’ of the ECB (should they adhere to the prerequisites and the programmes’ requirements), and should deter speculators from driving up yields of the periphery to test the ECB. On the flipside, the full disclosure of the above will also allow the ECB to reveal the countries which are on assistance and provide a stark visual reminder to those involved of their weakened state and indebtedness to the ECB who could pull the plug if they fail to keep up with reforms.
The sterilisation of OMT purchases will soothe the frazzled nerves of those against monetary printing such as the Bundesbank, despite this having to a certain extent detracting from the potential effectiveness of the programme. Nonetheless, we believe it was necessary to include this somewhat negative point in order to gain the nod of monetary hawks in the ECB.
The easing of collateral requirements which saw the ECB suspend minimum credit ratings for collateral eligibility for members who are OMT eligible, should aid in severing the vicious cycle link between sovereigns and their domestic banks, as banks whose sovereigns are under the program will be able to refinance themselves sufficiently given the ability to pledge their sovereign’s bonds to the ECB as collateral to gain financing. Once again, it appears as if the ECB is trying to entice both Spain and Italy to apply for programmes under the ESM as both countries suffer from the vicious cycle of downgraded sovereigns and weakened banks (as the banks hold substantial amounts of sovereign debt).
The latest initiative by the ECB shows leadership in the right step by prominent characters in the continent’s much maligned horror show. With firm support from Chancellor Merkel and other important Eurozone policymakers, the OMT has the potential to “fully effectively backstop” the Eurozone from destructive scenarios, particularly one of current members leaving the currency bloc. Nonetheless, as Draghi mentioned, while significant progress has been made on the monetary front, “the need for structural and fiscal adjustment remains significant in many European countries.”
Given Draghi has done almost everything possible aside from embarking on quantitative easing which would be opposed by vital members of both the ECB and Eurozone leaders, the ball is now firmly in the court of politicians, with little more to be asked of Super Mario who has committed to “address severe distortions in government bond markets which originate from, in particular, unfounded fears on the part of investors of the reversibility of the Euro.” We continue to remain optimistic on Europe, and maintain our 3.0 Star – “Attractive” rating on the continent, with a view that the politicians will allow Draghi to feed them the cure and lead the way out of the debt crisis.