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How long can Draghi’s bond-buying bluff hold?

by Michael Collins, Investment Commentator at Fidelity

Capitalist banking systems are built on the confidence trick that people can get their money back at any time. Of course, if everyone sought their money at once, no one would get anything because the financial system would collapse.

The eurozone is being held together by a more-fragile bluff. This is the European Central Bank’s “outright monetary transactions” scheme that was announced in September last year. The scheme pledges to buy unlimited amounts of bonds of distressed sovereigns,a plan that was enacted by Mario Draghi to back up his comments two months earlier that the ECB would “do whatever it takes” to save the euro.

Draghi’s scheme is, so far, the masterstroke of the eurozone crisis because it papers over the ECB’s shortcomings as a central bank. Specifically, it skirts the ban on the ECB acting as a lender of last resort to governments, which means endlessly printing money to fund a government deficit or to repay bonds. This is an essential emergency power central banks have to stabilise the banking system, for banks and governments are entwined. Draghi’s scheme sidesteps this prohibition by promising to offset (or sterilise) any bond purchases by selling securities from non-struggling countries to keep level the eurozone money supply.

Draghi’s ruse is such a successful bluff no eligible country has called on it (though it has failed to get credit and economies moving in peripheral countries). Bond yields on troubled European sovereigns dropped from panic levels when the scheme was announced and have stayed at manageable levels ever since, an effect Draghi praised as “positive contagion”.2 It’s almost like bond investors and speculators think they are powerless against the ECB. But they aren’t, if enough of them fail to be intimidated, for the scheme has limits. If investors doubt the ECB’s ability to cap yields on distressed government debt and they baulk at buying these bonds, the scheme is sunk. For, if these circumstances arise, bond investors will have pushed the bond-buying needed to uphold faith in the euro beyond the ECB’s capacity.

Draghi’s confidence trick has been tested this year, yet bond investors and profiteers showed no signs of doubting its enforcement. The worry is whether the scheme can withstand other bruisings, let alone work as intended if enacted. For more tests, and big ones, are coming.    

Conditional aid

The first buffeting for Draghi’s ploy occurred after Italy’s inconclusive election in February left the country without a government for two months. Draghi’s scheme can only be enacted if a government agrees to implement austerity and free-market reforms – for a country must have sought help from Europe’s rescue fund, the European Stability Mechanism, to be eligible. Whoever thought there’d be no government to deal with? If investors and opportunists had boosted yields on Italian bonds to unsustainable levels in terms of Italy’s solvency, the ECB was powerless to act. But investors and traders stayed blasé.

The self-defeating aspect to the conditions tied to Draghi’s scheme is that these austerity requirements are the poison that thrust a country like Italy on an ungovernable path in the first place. The spending cuts and tax increases imposed after Italy’s creditors appointed Mario Monti as prime minister in 2011 pushed voters to the fringes that led to the country’s political limbo. The political stability of a country will be tested if more austerity must be inflicted to trigger Draghi’s scheme. Any political strife could spark a downward spiral where higher bond yields require more central-bank bond buying, which would entail more austerity, which would damage public finances, boosting yields, and so on.

Portugal, which is in the early stages of this bottomless twist, duly exposed another problem with Draghi’s scheme in June when the government nearly collapsed because voters are sick of the austerity tied to the EU-led rescue the country accepted in 2011. Portugal’s bond yields soared but the ECB was powerless to help because Draghi’s scheme doesn’t cover EU countries that are unable to sell bonds. This catch means the ECB is incapable of helping bailed-out countries re-enter bond markets by driving down yields to levels that will keep governments solvent. Thus, if Portugal’s political troubles persist, the country is more likely to need a second bailout. This would only further drain Europe’s pool of rescue money and inflict more austerity pain on the Portuguese.

Court stoush

The third (and probably biggest) test of the credibility of Draghi’s scheme occurred earlier in June when Germans, including political groups such as the Left Party, launched a legal bid in Germany’s Federal Constitutional Court to stop Germany taking part in any bond buying. The opponents of Draghi’s ploy claimed the ECB’s as-yet-unused powers violate EU rules banning the central bank financing governments and the constitutional principle of democracy (that politicians, not bureaucrats, are empowered to take political decisions). Germany’s government opposed the court bid so investors were fed media reports as Germany’s two most-powerful members of the ECB clashed as witnesses on the legality of the scheme.

Jens Weidmann, the head of the Bundesbank and a member of the ECB policy-setting board, said the proposed central-bank bond buying blurs fiscal and monetary policy (another way of saying printing money, for that’s done through fiscal policy) and encroaches on the responsibilities of elected officials. Draghi’s scheme was defended by Jörg Asmussen, Germany’s member on the ECB’s executive board, who said safeguards, such as waiting periods before a bond can be bought on the secondary market, prevent the scheme turning into central-bank government financing.3

The wizardry of Draghi’s unused tool is that it is all these things. While Germany’s constitutional court has no power to torpedo the scheme, it can effectively neuter it by preventing the Bundesbank joining in the bond purchases. The court is not expected to upend Draghi’s scheme – judges usually skirt decisions that have huge political consequences, wisely preferring that politicians make these calls.

The court hearings failed to budge bond yields much, even though Asmussen said that the ECB scheme was “effectively limited” in terms of its bond-buying capacity, confessing the ECB declared it “unlimited” on its creation “to convince market participants of our seriousness”.4 These limits include that only bonds with three years left to maturity can be bought. Maybe investors were reassured that no verdict is expected until later this year. But the attack on Draghi’s scheme from Germany should have reminded investors that the Bundesbank opposed his ploy from the outset and that the German population, according to opinion polls, is against any ECB-led bond buying. Rising bailout fatigue among Germans is a mounting risk for the euro. It could yet rise to levels that would make Draghi’s scheme stillborn.

Thanks, Ben

Draghi’s ruse could be tested again soon enough. Greece is ever closer to collapse, an event that would trigger bank and bond runs in other troubled countries. Mediobanca, Italy’s second-biggest bank, warned in June that the country might need an EU rescue within six months because the recession and the credit crisis for large companies are deepening, to the detriment of government finances.5 Italy’s politics will only become more unstable now that Italy’s supreme court has confirmed a jail term for former prime minister Silvio Berlusconi for tax fraud. Spain is another concern because Spanish yields rose to worrying levels in June as a scandal over slush funds prompted calls for Prime Minister Mariano Rajoy to resign. A eurostat release in July confirmed that austerity is boosting government debt-to-GDP levels to levels that could erode investor confidence.6 Italy’s ratio of government debt to GDP stood at 130% in March, Portugal’s was at 127% and Spain’s at 88%. (Greece’s debt level was at 161% of output.)

Another test of the viability for Draghi’s scheme could be a general rise in global bond yields if the US economy improves enough for the Federal Reserve to end, or even reverse, its quantitative-easing program for US Treasuries, which are the benchmark for world markets. The Fed’s asset-buying since 2009 and concerns about deflation have sent global bond yields to record lows in recent times. While inflation expectations are still negligible, US bond yields rose more than 100 basis points in May and June when Fed officials started talking about trimming their support. On August 12, Italian and Spanish 10-year government bonds were trading at about 160 to 200 basis points above equivalent US debt respectively. That’s all well and good when US 10-year bonds are trading at 2.6%, as they were on that day. How will the ECB react, though, if US yields jump to 4.5%, to send Italian and Spanish debt into the solvency red zone (especially as higher interest rates will further cripple their economies at the same time)? Analysts generally see that if Italian and Spanish government bond yields exceed 7% then the government debt-to-GDP ratios will enter an upward spiral that will ultimately spell default. (The average interest rate at which governments renew debt generally must be below nominal GDP growth rates for debt-to-output ratios to fall.)

Investors received a big indication of how panicked the ECB is about the challenge of rising US bond yields when Draghi in July ditched restrictions on the ECB predicting monetary-policy settings. He said the ECB would keep the cash rate at its record low of 0.5%, or even lower, “for an extended period of time”.7 Many analysts took this statement to be another bluff (one that highlights how pessimistic the ECB is) rather than a commitment by the ECB to allow inflation to rise to higher than normal before lifting rates.

Draghi is a clever man in charge of a pretend central bank (for it’s only equipped to fight inflation, not a banking-turned-sovereign-debt-and-unemployment crisis). He must guess that bond investors will soon figure out that a stateless central bank defending a stateless currency is so hamstrung politically that it carries far less firepower than, say, the Federal Reserve has over the US economy and US dollar. If his outright-monetary-transactions bluff collapses, he may well have other tricks ready to suppress yields on struggling sovereign debt and save the euro (without which there is no need for the ECB). If Draghi is out of surprises, he can be thanked for buying time for politicians to come up with durable solutions to the eurozone’s woes. Oh, that’s another flaw with Draghi’s scheme; it removed the pressure for politicians to act. So they haven’t.  

Financial information comes from eurostat and Bloomberg unless stated otherwise.



[1] The ECB said when announcing the scheme that “no ex ante quantitative limits are set on the size of Outright Monetary Transactions”. ECB “Press release. 6 September 2012 – Technical features of Outright Monetary Transactions.” ecb.com

[2] Bloomberg News. “Draghi hails ‘positive contagion’ as euro markets stabilise”. 11 January 2013. http://www.bloomberg.com/news/2013-01-10/draghi-says-euro-area-economy-should-recover-later-in-2013.html

[3] Taken from media reports. Telegraph “Germany’s brother gladiators battle over euro destiny in constitutional court.” 11 June 2013. http://www.telegraph.co.uk/finance/financialcrisis/10114226/Germanys-brother-gladiators-battle-over-euro-destiny-in-constitutional-court.html?fb. Bloomberg News. “ECB crisis-plan judges focus on limits to monetary policy.” 12 June 2013.

[4] Jörg Asmussen, member of the executive board of the ECB. Introductory statement by the ECB in the proceedings before the Federal Constitutional Court. 11 June 2013. http://www.ecb.europa.eu/press/key/date/2013/html/sp130611.en.html

[5] The Telegraph. “Italy could need EU rescue within six months, warns Mediobanca.” 24 June 2013. http://www.telegraph.co.uk/finance/economics/10139939/Italy-could-need-EU-rescue-within-six-months-warns-Mediobanca.html?fb

[6] Eurostat website. “Quarterly government debt.” Government consolidated gross debt as a percentage of GDP. Last updated 22 July 2013.  http://appsso.eurostat.ec.europa.eu/nui/submitViewTableAction.do

[7] Reuters. “Draghi says rates will remain low for extended period.” 4 July 2013. http://www.reuters.com/article/2013/07/04/ecb-rates-outlook-idUSL5N0F734420130704

 

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