A week after its unveiling, the European Central Bank’s new bond-buying plan isn’t holding up to scrutiny on Wall Street.BofA economist Laurence Boone was never too pumped – in a note to clients following the announcement, she explained why the ECB’s was more negative than positive.
The problem: conditionality. Boone wrote that the number-one negative aspect of the ECB’s new “outright monetary transactions” (OMT) is that “emphasis on conditionality [was] even stronger than we had expected …significantly lowering the probability that a country will apply for EFSF/ESM support.”
However, in a note to clients today, Boone seems to have reconsidered the conditionality aspect of the program.
There’s really no good news, though: it’s still terrible for progress on the euro crisis front, but for a whole other reason.
Boone thinks that ultimately, conditionality won’t be enforceable by the ECB, which may sound familiar to anyone who’s been following the euro crisis in recent years. Think about the last time the central bank tried to intervene in Italian bond markets via the SMP (the bond-buying predecessor program to OMT). It all fell apart. Italy didn’t comply with conditions for financial assistance, and sovereign bond yields ended up going higher, further stretching the Italian government’s borrowing costs.
Boone is effectively calling the ECB’s bluff, saying she doesn’t think they’ll stoop to abandon a country mid-program this time, due to the ramifications of such a decision:
…leaving a country at the mercy of the market would destabilise euro
As soon headlines such as “the ECB no longer supports Spain as it does not meet its commitments” hit the wire sovereign yields would soar, the country would be denied market access, raising the question of default and its systemic effects on the euro area banks. This would have potential spillover effects on other fragile countries, such as Italy. After all, Greece has been missing its program conditions for more than a year and the European authorities – including the ECB through its support to the Greek banks – have not stopped funding the country.
Given the absence of credibility when it comes to enforcement, we identify two types of equilibrium in the short term:
Unstable equilibrium: the conditions imposed for access to ECB support are such that the country has no interest in seeking help, and the ECB remains “respectable” by not intervening.
Stable equilibrium: the conditions are milder and the ECB intervenes quickly and potentially buys up large amounts of debt.
In the first equilibrium scenario, as the ECB knows it does not have the means to carry out its threat to stop purchases of debt, it seeks to deter countries from requesting support in the first place. The conditions it sets are so harsh as to preclude any request for support. An IMF-style programme would likely deter Spain: Ireland is recovering slowly, but thanks to its strong export capacity; and Portugal is in a recession for the second consecutive year and its growth prospects and ability to restore its public finances are weak and looking increasingly remote. Furthermore, the political cost implied by the loss of sovereignty associated with these programmes is also a deterrent. Spain, with the prospect of regional elections in late October and arguing that it has put the right reforms in place would have little reason to ask for ECB support while it can fund itself.
Alternatively, in the second equilibrium scenario, the ECB provides an incentive to request support. Conscious of its lack of coercive power the ECB does not wish to put this to the test so the aim of the OMT programme is to prevent speculation against euro area member states and the viability of the euro itself. In this scenario, the ECB lowers the cost of entry into a programme by offering very mild conditions. For example, in the case of Spain it might require no more than the implementation of ongoing reforms (and no additional fiscal austerity or pension reform). For Spain the cost of seeking support would be little more than the political cost associated with a programme (though the ECCL is designed to minimise that) and the cost of an audit of its public finances. It would therefore be in the interest of Spain to seek help quickly and request the protection of the ECB.
If conditionality is really just a shell game at this point, it effectively puts the euro area right back where it was before last Thursday’s ECB meeting – in anxious, wait-and-see mode.
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