Now that the immediately negative market reaction to the European Central Bank’s decision Thursday is past, it is worth revisiting the results and assessing ECB president Mario Draghi’s remarks in the post-council press conference.
As the markets indicate -- albeit amidst shallow trading activity -- Mr. Draghi did deliver some serious net positives when it comes to signalling a definitive policy platform for the ECB in the weeks ahead. The core to this assessment should be his comment that he will focus on the shorter end of the peripheral bonds’ maturity curve and that this will be consistent with three things:
-- No commitment to sterilization;
-- A commitment to addressing the issue of the bonds’ subordination in any future restructuring;
-- And a commitment to targeting “traditional monetary policy” objectives.
Let me explain why I think these are significant game-changers for the ECB, and potentially for the euro area.
For some years, even before the financial crisis, the ECB has attempted to focus European policy-makers’ attention on the need for structural reforms. In the past, this was accompanied with threats of not engaging in an accommodative monetary policy to drive up anemic euro-area growth. In the current environment – with all leading economic indicators pointing to continued recession across the common-currency area in the second and third quarters – such threats are not credible.
Hence, for the ECB to stay on its message promoting long-term structural reforms, it must pursue seemingly contradictory objectives of sustaining pressure on the peripheral sovereigns to reform (in other words not easing their borrowing conditions too much) while giving them enough room to actually make reforms feasible. To this, Draghi delivered a rather coherent policy outline. The ECB may act to:
– Reduce the immediate pressure on funding indebted and deficit-laden peripheral countries by targeting its securities market operations at short-term borrowing rates;
– Increase pressure on the peripherals to pursue longer-term reforms by raising the over-all slope of the yield curve and making longer-dated debt prohibitively expensive to issue, compared to shorter-term debt;
– Support enhanced transmission of lower short-term rates into the real economy by possibly not sterilizing bond market interventions;
– Reduce future balance-sheet headaches for the ECB by buying only short-dated government bonds and then allowing normal debt maturity to reduce ECB exposure over time.
There is an added bonus to the Draghi scheme. By committing the bank to address the problem of subordination of private debt holders to the official bondholders (namely, the ECB and national central banks) in the event of future restructurings, Mr. Draghi simultaneously strengthened his case for meeting objectives one and three above. First, removing subordination will mean improved (albeit marginally) pricing for the peripheral bonds at risk of such restructuring. Second, it should also improve peripheral banks’ capital positions, as it will put a floor under the peripheral bond prices. Furthermore, removal of subordination will have an impact across the entire yield curve. This is the good news for Italian and Spanish banks that bought large swaths of shorter-dated (one to three years) sovereign bonds from their respective governments after the injection of cheap three-year loans from the ECB under its long-term refinancing operations between December and February.
The best part, from the point of view of skeptical German, Finnish and Dutch ECB members, is that the central bank will not commit to sacrificing longer-term policy flexibility by expanding its securities market program (SMP) at the longer end of the yield curve, thus reducing over-all risks to monetary policy in the future.
Time will tell, but the latest scheme concocted by Mr. Draghi might buy the euro area enough time (before the real economy starts showing more trouble ahead) to work through September and October on a more permanent set of solutions.
Dr. Constantin Gurdgiev is adjunct professor of finance at Trinity College, Dublin