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Bonds to the rescue: ECB reveals its Eurozone rescue plan, but will it be enough?

European Central Bank President Mario Draghi announced that the ECB will buy back bonds on the secondary market in a bid to curb the debt crisis. AAP

Yesterday, the European Central Bank’s president, Mario Draghi, unveiled the European Central Bank’s rescue plan for the Eurozone. Mr Draghi said that the ECB is now prepared to buy sovereign bonds of one to three-year maturity through Outright Monetary Transactions (OMTs).

The decision to do so comes as no surprise. However, it marks an important upgrade in the bank strategy to deal with the Eurozone debt crisis.

The ECB has already bought relatively large quantities of bonds since the beginning of the crisis. Yet, OMT purchases are different in one important aspect. In the words of Mr. Draghi, OMTs have no “ex-ante quantitative limits”. That is, there is no theoretical limit to the amount of bonds that the ECB will buy from now on.

In addition, this new bond purchase programme includes two other important elements. First, the ECB will not claim senior creditor status, meaning that in the event of a default it will not seek to be repaid ahead of other creditors. Second, to qualify for the programme, countries will have to satisfy a number of conditions, including the implementation of budget cuts and economic reforms.

Why OMTs might work

Following ECB’s announcement, Spanish 10-year bonds declined to 6.09% from 6.41% on Wednesday. Similarly, Italian 10-year bonds went from 5.51% to 5.36%, driving the spread against the German bonds below 3.7%. Stock exchanges increased by 4.9% in Spain, 4.3% in Italy, 3% in France, 2.9% in Germany, and 2.1% in the UK.

While these immediate positive reactions are not necessarily indicative of long-term success, there are reasons to believe that the decision of the ECB might turn the European situation around.

Through OMTs, the ECB can stabilise the yields on sovereign bonds, allowing countries like Italy and Spain to obtain finance at a reasonable cost. In fact, it seems that markets are now putting an irrationally high risk-premium on Italian and Spanish debt. The guarantee of an unlimited ECB intervention would reassure markets and make sovereign bonds more attractive to investors.

The plan signals the commitment of the ECB to stand in support of the euro at all costs. In fact, the signal might be strong enough to stabilise markets without even need for the ECB to actually buy large quantities of bonds.

Why OMTs might not work

On the other hand, there are three reasons for concern with the ECB plan. These are forcefully voiced even within the ECB governing body, particularly by Germany.

One is that the unlimited purchase of bonds financed by printing money might trigger strong inflationary pressures in the Eurozone. Whether or not inflation will actually increase depends on (i) the actual amount of bonds that the ECB has to buy and (ii) the extent to which the impact of bond purchases on money supply is sterilised. In fact, the ECB is committed to full sterilisation, which should be achieved by offering interest-bearing deposits to banks equal to the total amount of government bonds it holds.

The second major concern is the potential for moral hazard associated with the monetisation of sovereign debt. In practice, the ECB might become a lender of last resort for national governments. Knowing that their debts will be paid by someone else in the end, some of these governments — especially those facing strong opposition to prolonged measures of fiscal austerity — could revert to the same type of profligate fiscal behaviour that caused the crisis in the first instance. The imposition of conditions to qualify for OMT is an attempt to avoid this moral hazard effect.

The third concern is that OMTs do not address the structural problem of the peripheral European countries — namely the stagnation of the real economy. In this respect, OMTs could be a buffer, but not a solution to the crisis. Many would agree that the crisis will end only once the periphery returns to solid, positive growth. Being able to borrow at a reasonable cost might be a necessary condition to relaunch growth, but certainly it is far from being sufficient.

Praise to the ECB, final call for governments

This last point suggests that Europe’s fate is still very much in the hands of its national governments. On balance, the plan announced by the ECB can be expected to result in lower bond yields. This in turn will provide a much needed window of opportunity for the peripheral countries to focus on domestic reforms to promote economic growth.

Whether or not national governments will take advantage of this window of opportunity is the real matter of concern. As the recent experience of Italy shows, the road to reforms is paved with political-economic constraints that might become insurmountable for short-sighted national governments.

In spite of the criticism of the German Bundesbank, the ECB decision to purchase sovereign bonds seems to be within its monetary policy responsibilities and in line with its mandate to consolidate the euro. It would be difficult to argue otherwise, since the crisis is threatening the survival of the euro itself.

Some observers might say that by making this decision the ECB has taken a more politicised role. In fact, it is quite the opposite. By making a decision that is consistent with its mandate and responsibilities regardless of the pressure from the largest economy of the union, the ECB has shown its independence and autonomy.

So, today the ECB is to be praised. After months of uncertainty, it has finally taken a decisive step forward. But this is probably as far as it can go. No bond purchase programme can substitute for economic reforms and growth. National governments need to understand this and act accordingly. The fatal mistake that they could make at this stage is to believe that a lender of last resort is also a panacea.

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