Last week, ECB President Mario Draghi walked the tight rope when he attempted to keep markets buoyed by not deflating the bubble of market expectations he created with previous pronouncements. Judging by the short-term reaction, his feat was successful.
The ECB announcement of the Outright Markets Transactions (OMT) operations was consistent with Mr. Draghi’s earlier statements. It also revealed some key disclosures about the program – enough to wet the market’s appetite for risk.
ECB purchases of government bonds of one-to-three years’ maturities in theoretically unlimited amounts might sound like a big-bang step and a departure from the previous ECB programs. However, in reality, the OMT is just another, more elaborate attempt to buy time in a hope that the euro area member states can master political will and economic creativity (hereto unwitnessed in the past) to design, deploy and deliver on structural reforms.
Lack of preset limits on bonds purchases is a positive for the OMT relative to previous ECB programs, but its construction is purely theoretical. Physical limits on purchases will be set by two bounds: the vastness of the potential demand for purchases (Italy and Spain alone can require as much as €530-billion in program funding to cover bonds redemptions for 2013-2015) and the sterilization operations that will aim to keep the real money supply constant over time.
The ECB’s acceptance that the OMT purchases will rank equally with privately held bonds in the event of a default is a strong positive for the markets, but these do not eliminate – with EFSF and ESM still ranked senior – a two-tiered market for credit risk in the euro area.
The OMT will be focused on the one-to-three year maturity horizon, which works with the economic logic I outlined in the earlier analysis. Yet, since the ECB will hold OMT purchases to maturity, there is a potential redemption cliff for the sovereign bonds looming on the horizon for 2014-2015, that can be exacerbated by coincident maturity of the LTROs. In other words, the timing of bonds purchases and the timing of exits from LTROs will have to be managed carefully, lest the ECB risks creating a tsunami wave of asset disposals in the future.
Access to the OMT involves full macroeconomic conditionality in the form of compliance with the Enhanced Conditions Credit Line (ECCL) and the IMF oversight (sought by the ECB). This will subject states participating in the OMT to a Troika-like engagement and dramatically reduces the likelihood of any country going into the OMT.
Over all, the OMT can only allow the governments some time (1-2 years) to put structural reforms in place, but will only marginally ease the burden of such reforms. OMT does not resolve the euro area debt crisis itself.
The real problem is that euro area governments are now faced with the same set of problems they faced before the ECB announcement: the problem of designing, deploying and delivering on the reforms.
Designing the required reforms is not as straight forward as one can imagine. Of the three states (Greece, Ireland and Portugal) currently within the IMF/EU/EFSF Troika-program, only Ireland and Portugal have managed to design some sustainable reforms. None, after years of attempting such designs, have managed to complete the process. No euro area government, save Germany, Finland and Austria has managed to produce a credible set of policy reforms to restructure their economies from the perpetual dependence on debt financing and government spending to generate growth. No euro area economy can currently survive without exploiting imbalances in global trade and investment flows.
Once the reforms are designed, the Euro area governments will still be required to deploy them, which is a painful and risky process that has to be sustained over time and across political elections. Of the three states currently in the Troika program, only two have managed to partially deploy these programs, and with a varying degree of success.
Once deployed, the reforms must deliver desired outcomes: meeting strict targets on fiscal performance while achieving sustained growth to finance fiscal consolidations is not an easy task. Some years into the process, none of the three states participating in Troika programs have managed to deliver such outcomes.
The OMT is not a solution to the euro area crisis. Instead, it is a new round of kicking the proverbial European can down the well-worn road. The short-term gains from Mr. Draghi’s comments cannot be sustained unless the political process of structural reforms yields tangible and convincing results. So far, euro area’s historical record on this is far from confidence-instilling.
Constantin Gurdgiev is adjunct professor of finance at Trinity College, Dublin.