Markets got a short burst of support this week when analysts said the European Central Bank (ECB) may restart a bond-buying exercise known as the Securities Markets Programme (SMP) after a 20-week hiatus. Unfortunately, SMP alone isn’t likely to be enough to assuage concerns about the euro zone and its weaker members.
What more is needed? There’s a plan afoot to have the ECB act as a bond buying agent for the European Union’s temporary bailout fund, known as the European Financial Stability Facility (EFSF), and its planned permanent successor, the European Stability Mechanism (ESM).
Jean-Claude Juncker, head of the Eurogroup organization of euro-area finance ministers, hinted at the plan when he told Süddeutsche Zeitung last weekend that the EFSF and ECB are working together to reduce borrowing costs. Meanwhile, ECB president Mario Dragi has been holding meetings across Europe to discuss the idea. During a landmark speech in London on July 26 he said the ECB was “ready to do whatever it takes to preserve the euro.”
How would it work? Per the EU summit statement, the ECB would act as an “agent” for the rescue funds, buying bonds on their behalf on the primary market. The primary market is where the borrowing costs of governments are determined–and the ECB isn’t allowed to intervene there. But the EFSF or ESM (once it’s operational) could buy government bonds on the primary market though the ECB. The only limit would be the size of the two rescue funds, which now have a combined firepower of over half a trillion euros, even after committed rescues, but which could be larger if they were leveraged.
Then, as Draghi signaled last week in London, the ECB could buy existing government debt if high yields hamper the operation of monetary policy (the justification for the SMP). Its ability to dampen bond yields would thus be magnified by buying for the EFSF and ESM in the primary market while buying on its own behalf in the secondary market.
This one-two punch would add firepower–or, at least the appearance of it–to European rescue efforts often criticized for not being big enough. Previous ECB bond purchases, now totaling about €212 billion, suffered from the fact that they had to be “sterilized”–that is, for the equivalent amount of cash to be sucked out of the money supply to prevent inflation–which somewhat limited how much the central bank could buy. By contrast, the rescue funds will be able to buy debt per their extended mandate, without restriction other than their funding capacities.
Perhaps most importantly for the Germans, any purchases by the EFSF would be subject to “conditionality,” since governments would have to request the transactions. This would ensure the continued independence of the ECB while curtailing the bad incentives and “moral hazard” that the Bundesbank fears could result from overly lenient monetary policy.
There are concerns nevertheless. Harvard’s Martin Feldstein argues it’s a mistake for the ECB to buy select government bonds, no matter how the deals are dressed up. He says it would be better for the central bank to buy a neutral basket of bonds, perhaps weighted by the capital contributions of the 17 euro zone nations.
This approach would sufficiently benefit Italy and Spain, the third and fourth largest euro economies. Unfortunately, it would have an even bigger impact on Germany, whose three-year note yields are already below zero. For this reason, some argue that if the ECB is to take this route, it might as well call its action “quantitative easing” and leave the EFSF and ESM out of the equation. But QE is politically charged and not on the cards anytime soon.
It’s safe to say that the Aug. 2 ECB meeting will be even more closely watched than usual as expectations are high for next steps. The markets are virtually counting on it.