The government shutdown in the United States and the prospect of a U.S. debt default are dominating the discussion in financial markets.
ISI vice chairman Krishna Guha warns, however, that investors shouldn’t forget about the German Constitutional Court, which is expected to rule on the legality of the European Central Bank’s program of “Outright Monetary Transactions” (OMT) later this month — a policy tool that is said to have brought calm to eurozone (and thus global) markets since the summer of 2012.
“We view the upcoming ruling from the German Constitutional Court on the ECB’s OMT program as a bigger tail risk than U.S. government shutdown or default,” says Guha in a note to clients. “While the probability of an adverse ruling is low — in the region of 5-10 per cent — the cost of such a ruling for the eurozone and global asset markets would be extremely severe.”
Guha says a ruling against OMT would bring “redenomination risk” back to eurozone assets — the premium investors demand to protect themselves against the risk that peripheral eurozone sovereign bond markets blow up and countries exit the euro.
“With the return of redenomination risk, the tentative and partial revival of private sector cross-border financial flows in Europe would swing into reverse,” says Guha. “The massive loss of wealth and further constriction of credit supply in the periphery would push these nations back into deep recession. And in this setting, the trigger for fatal, self-fulfilling runs could emerge, whether in the form of political upheavals, bank failures or other endogenous disruptions.”
So, what are the odds that the German Constitutional Court rules against OMT?
Guha lays out three possible scenarios:
- Our baseline scenario is represented by a “yes, provided that…” the court would find OMT in compliance of German basic law, but probably with some token requirements, such as updating the Bundestag about the impact of the program should it ever be activated. These largely symbolic conditions would have little or no impact on the functioning of the program. This would be welcomed by the markets and eliminate a non-trivial source of tail risk. We rate this as a very likely outcome, with a probability of around 70-75 per cent.
- The risk case is that the Court finds the OMT as presently structured in violation of German basic law, or imposes conditions that cannot be met without substantially weakening the program or creating different legal problems. Such a ruling would stop German institutions including the Bundesbank from participating in the OMT at least until it was restructured in a way that brought it into compliance with German constitutional law. Such an outcome would have serious effects on a variety of asset classes. We assign this outcome a low, but troublingly non-trivial probability of 5-10 per cent.
- Finally, the German high court could postpone judgment on the OMT and refer the case to the European Court Of Justice to rule on the legality of the OMT under European law before it rules on whether the OMT is constitutional under German law. This would constitute an interesting precedent. The German constitutional court has never taken such a decision before. Countries that are exiting full bailout programs in 2014, are currently expected to apply for a precautionary credit line and could potentially benefit from OMT, such as Portugal, could come under renewed scrutiny. However, the ECJ would be careful not to jeopardize the eurozone and would almost certainly find OMT in compliance with existing European law. Conditional on going down this path, it is very likely that the German Constitutional Court would subsequently find the OMT constitutional under German law. We rate the probability of referral at 20 per cent.
“Our probability of 5-10 per cent on the risk case is probably somewhat higher than consensus,” says Guha. “We get there not because we think there is a sizeable chance that the German Constitutional Court will deliberately torpedo the program, but because it will be difficult for the Court (made up of lawyers not economists) to judge which of the conditions it might require to bring the program into compliance with German law would jeopardize its effectiveness.”