OMT: Offering hope
The European Central Bank meeting held last week, unlike previous instances, generally seems to have met the upper end of expectations. The governing council outlined the framework of its new bond buying facility, the Outright Monetary Transactions (OMT) plan. This will replace the Securities Markets Programme (SMP) with a framework that allows for unlimited government bond purchases, in the secondary market, of countries under the European Financial Stability Facility (EFSF) and European Stability Mechanism (ESM) programmes.
Draghi highlighted that the ECB’s independence is being preserved and the OMT will be within the framework of its mandate. German Chancellor Angela Merkel also gave her backing in this respect. The plan is being framed within the institution’s responsibility for monetary stability and the need to deal with distortions in the transmission mechanism and hence falls within the ECB’s mandate.
Key features of the OMT include the following:
Unlimited purchases of government bonds with outstanding maturities of between one and three years;
Strict and effective conditionality: countries under the programme will have to adhere to the strict fiscal policy adjustments;
ECB secondary market purchases will be part of a programme that also entails primary market purchases by the EFSF / ESM;
OMT plans may apply to countries in future programmes such as possibly Spain or Italy; current programme countries like Ireland and Portugal will apply only when trying to regain market access;
The operations will be sterilised; this means the ECB will take measures (for example by accepting deposits to offset bond purchases made) to avoid an increase in money supply.
The revamped bond buying plan will hopefully be more successful than its predecessor because the strict conditionality and its unlimited nature will make it more credible to investors. In fact, another salient characteristic of the OMT that should contribute to this aim is the acceptance by the ECB of the same level of credit risk as private bondholders. Fitch Ratings commented recently that the seniority of the ECB, which excluded it from the Greek bond restructuring in April, could have hampered the positive impact of bond purchases by raising the risk premium demanded by private investors as compensation for their subordination. Transparency is also being enhanced, with the ECB committing to publish its holdings regularly.
The markets, at least so far, have welcomed the plan. The euro rose following the announcement, and is now trading close to three month highs against the US dollar. Borrowing costs for Spain and Italy have been pushed lower. Spain’s 10-year government bond is currently yielding approximately 5.7 per cent (vs 6.4 per cent a week ago and the euro area high of 7.6 per cent in July). Italy’s 10-year government bond is yielding 5.1 per cent (vs 5.5 per cent a week ago). Credit markets generally rallied, with spreads on periphery corporate bonds tightening in a reflection of improved market sentiment.
Several obstacles remain in the way of financial market stabilisation and economic recovery. A reversal in sentiment is possible even in the very short term. Whilst most are expecting the German Federal Constitutional Court not to block the ESM (a decision to be taken after this article went to press), the doubts related to this decision exposed the level of concern in the markets. Investors await further clarity on whether Spain will make a formal bailout request – a continued delay and lack of clarity could possibly see borrowing costs rise again. In Greece, there is reluctance by coalition partners to approve the spending cuts being requested by the EU Commission, the ECB, and IMF troika. The Dutch elections could also add another dose of uncertainty.
Beyond the requirement for the successful setting up and implementation of the latest ECB bond buying plan, a convincing economic recovery in Europe will in the long term depend on the implementation of reforms, particularly in periphery countries. Spain will certainly benefit from regaining markets access at stable and affordable rates. However, several structural problems, including the severe banking crisis and persistently high unemployment, will not fade away. Italy’s economy shrank more than expected during the second quarter, and is in its fourth recession since 2001.
While it is still unclear whether the OMT plan will be a definite turning point in this crisis, it remains a constructive step forward. The plan is likely to be useful in helping reduce the possibility of a self-fulfilling liquidity crisis by establishing a positive feedback loop. It will provide liquidity to governments, giving them time in theory to consolidate fiscal positions and implement reforms. In turn, it is hoped that this will improve growth outlooks, reduce risk premiums and encourage the expansion of credit.
This article is the objective and independent opinion of the author. The information contained in the article is based on public information. Curmi and Partners Ltd. is a member of the Malta Stock Exchange, and is licensed by the MFSA to conduct investment services business.
Mr Falzon is a credit analyst at Curmi and Partners Ltd.