The Eurosystem’s Outright Monetary Transactions – the ECB’s intervention in management of sovereign debt

Mario Draghi, a president of the European Central Bank introduced the technical features of the Eurosystem’s Outright Monetary Transactions in secondary sovereign bond markets during the press conference on the 6^th of September. The ECB’s approved conditions of programmes allow intervening in the financial markets and absorbing high yield sovereign debt securities.  The special programmes could relief borrowing cost of issued sovereign bonds through the ECB’s purchase of securities those are not accepted by investors. Considerations regarding the monetary and fiscal policies interactions intensified during the period of financial instability. However, interventions of central banks in the management of the sovereign debt are still assessed contrary.

According to the “Interactions Between Sovereign Debt Management and Monetary Policy Under Fiscal Dominance and Financial Instability” (No. 3 of OECD Working Papers on Sovereign Borrowing and Public Debt Management), published by Blommestein, H. J. and P. Turner (2012), it is difficult to separate monetary and public debt management as both policies are involved in the sales of sovereign debt to private sector, though in different forms. New issuance of sovereign debt securities or regulation of the supply and demand of sovereign debt affects investment decisions of firms and households, and impacts on macroeconomic development. Moreover, monetary and fiscal policy interactions, mandates, accountability and potential conflicts of policies were reviewed in the ECB’s article “Monetary and Fiscal Policy Interactions in a Monetary Union” published in July’s Monthly Bulletin, 2012. So, the ECB’s decision on the Eurosystem’s Outright Monetary Transactions could not be judged as urgent and reckless.

A necessary condition for Outright Monetary Transactions approved by the Governing Council of the ECB is strict and effective conditionality attached to an appropriate European Financial Stability Facility/European Stability Mechanism (EFSF/ESM) programme. Such programmes can take the form of a full EFSF/ESM macroeconomic adjustment programme or a precautionary programme (Enhanced Conditions Credit Line), provided that they include the possibility of EFSF/ESM primary market purchases. The transactions will be focused on the sovereign bonds with a maturity of between one and three years with no ex ante quantitative limits in the size of the OMTs. The same pari passu treatment will be accepted for private and other creditors regarding the issued bonds by euro area countries and purchased through the OMTs. Moreover, the liquidity created through the OMTs will be fully sterilised and information about the OMTs holdings will be publicly available. It is also expected that the IMF will be involved into the design of the country-specific conditionality as well as the monitoring of such programmes. 

If we assume that according to the borrowing demand and high costs of Italy and Spain, those two countries will enter the OMTs programmes, what are the high quality securities the ECB is going to sell in order to offset increased liquidity?

How stable and liquid is physical gold?

The World Gold Council is an association comprised of 23 members of the world’s leading gold mining companies those represent approximately 60% of global corporate gold production.  The main goal of the organization is to develop gold market by stimulating and sustaining demand for gold.  Historically, gold is used as a hedge against inflation and deteriorating currencies thus, according to the prolonged financial crisis, the World Gold Council suggested that added gold to the high-quality liquidity buffers could bring stability to the banking system. Additionally, due to gold’s characteristics the World Gold Council expressed believe that gold could be included in banks’ reserve asset portfolios and be used as collateral for liquidity financing.  So could gold be acknowledged as a stable and liquid global currency which is equivalent to high-quality capital?

The physical gold may be purchased from mine producers those refine gold according to the London Good Delivery – the internationally acceptable standards and in the global OTC market.  The reference gold prices are fixed in London twice during the day and either the morning (AM) or the afternoon (PM) fixed price is used for pricing long term contracts. According to the international standards, the bars must be at least 995 parts gold of 1000 and weight between 350 and 430 fine ounces. The physical gold is mainly stored at the Federal Reserve Bank of New York and the Bank of England – the largest custodians safeguarding other central banks’ gold reserves. However, investors may choose a broad array of financial products such as Exchange Traded Funds, Futures and Options, Warrants, Gold Mining Stocks, Gold oriented funds and others those provide opportunities without a purchase of physical gold to gain from the movements of gold price.  

According to the Gold Demand Trends, a report for second quarter 2012 which was prepared by the World Gold Council in August 2012, the total amount of the gold purchased by official sector institutions was 157.5 tonnes and accounted for 16% of overall Q2 gold demand. During the first quarter of 2012, official sector purchased 254.2 tonnes of gold which reflects a 25% increase compared to the 203.2 tonnes of gold purchased during the first quarter of 2011. The biggest buyers were the National Bank of Kazakhstan, the central bank of Philippines, the central bank of Russia, the National Bank of Ukraine, the central bank of Turkey and South Korea’s central bank.

Going back to the World Gold Council’s suggestions, the advantage of established gold as banks’ reserve asset is elimination of credit risk; however, market and liquidity risks may be even severe for financial stability.

The main goal of central banks is to maintain price stability. Moreover, deteriorating exchange rates of domestic currencies reflect the worse economic state of the country.  Reduced purchase power of domestic currency forces governments to reconsider economic policy. Debts of governments and corporations are covered by collateral assets and guarantees. So creditors have legal obligations to repay debts. Market value of equity depends on the asset allocation decisions. In all these cases the responsibility is assigned for managing uncertainties and made decisions.

So will the World Gold Council take responsibility to maintain stable gold price and even more will it emerge as a key authority responsible for the stable global financial system?

Value creation should be a priority of stability policy, shoulddn't it?

US Treasury Secretary Timothy Geithner held private talks with German Finance Minister Wolfgang Schaeuble and ECB’s President Mario Draghi this week. The other confidential meeting was carried between ECB’s President Mario Draghi and Bundesbank Chief Jens Weidmann before the ECB’s monetary policy vote on Thursday, 2 August. Last week M. Draghi’s publicly announced to do whatever it takes in order the Spain’s and Italy’s borrowing costs were reduced and euro stability was maintained. However, Germany’s position remained against resuming the ECB’s government bond buying programme and issuing Eurobonds. Broadcasted the US Treasury Secretary’s interview with Bloomberg on Wednesday, 1 August revealed T Geithner’s concerns about market stability and desires to sustain investors’ confidence, though usage of the euro zone's rescue funds is not clear. Does it mean that €500bn funds of European Stability Mechanism could be used to implement reforms not necessary related to the recapitalization of European banks and sovereign bonds purchase programme?

The slowing down global economy growth was captured with different statistics. However, World Trade Organization’s observations may reveal some new aspects of slowing growth. According to the World Trade 2011, Prospects for 2012, WTO’s press release on 12 April 2012, the world trade expended in 2011 by 5.0%, which is a sharp deceleration from the 2010 rebound of 13.8%. Moreover, it was predicted that the growth would slow further to 3.7% in 2012. On World Trade Report 2012 released on 16 July, 2012, WTO focused on new international trade challenges – increased use of non-tariff measures. These measures reflect regulatory standards for manufactured and agricultural goods. So, political concerns about the health, safety, environmental quality and other social aspects may affect international trade even more than tariffs.

Consequently, value creation should be a priority of stability policy, shouldn't it?

Are negative interest rates a signal of excessive liquidity?

International Monetary Fund warned on increased risks to financial stability in the Global Financial Stability Report released on 16 July, 2012. Excessive European sovereign debts and concerns about the quality of banks assets were mentioned as the main threat to financial stability alongside with the uncertainties on the fiscal outlook and federal debt ceiling in the United States. Financial risks are understood as possibility of losing assets. So, shouldn’t quality of assets remain the main focus and concern?

It could be mentioned that prominent features of June and the first part of July involved further easing of global monetary policies. According to the Monetary Policy Meeting held in June 15, Bank of Japan will encourage the uncollateralized overnight call rate at around 0 to 0.1 percent. The US Federal Open Market Committee decided to continue purchasing Treasury securities with remaining maturities of 6 years to 30 years at the current pace and to sell or redeem an equal amount of Treasury securities with remaining maturities of approximately 3 years or less. The news about the expended operational twist by $269 billion through 2012 was announced on 20 June. The key ECB interest rates were cut by 25 basis points to 0.75% on 5 July. Monetary Policy Committee of Bank of England decided to increase size of Asset Purchase Programme by £50 billion to £375 billion on 5 July. The People’s Bank of China decided to cut one year RMB benchmark deposit and loan rates by 0.25 and 0.31 percentage points to 3% and 6% respectively on 6 July.

Similar remarks could be addressed to the quality of decisions in financial sector. Single supervisory mechanism for euro area banks and the concept to recapitalize banks directly through the European Stability Mechanism (ESM) may fail if banks’ business models are dysfunctional and they cannot sustain financial shocks. Banks’ insolvency arose due to inaccurate assets management and failed estimations. So, additional banks capitalization and facilitated access to attractive borrowing costs will hardly improve the assessment of viability of business plans/investment opportunities.

Moreover, could negative interest rates signal that liquidity is enough in the markets? Investors demand for credibility allowed Germany, Denmark, Finland, Belgium and France to borrow at negative interest rates. When investors chose sovereign bonds with negative interest rates they sink their savings. So, maybe liquidity is already enough and the main concern is to employ existing capital efficiently.

Could leaders of highly regulated institutions be easily replaced?

The FSA has announced about the misleading sales of interest rate hedging products to some SMEs on 29 June and confirmed that it reached agreement with Barclays, HSBC, Lloyds and RBS to provide appropriate redress where mis-selling has occurred. Barclays was fined £290m by authorities in the UK and the US following an investigation into the submission of various interbank offered rates. Chairman of Barclays, Marcus Agius resigned on 2 July, Chief Executive Bob Diamond and Chief Operating Officer Jerry del Missier resigned on 3 July. So, is it difficult to replace leaders of highly regulated and self–running business?

According to the FSA sold interest rate protection products involved “caps” those fix the upper limit to the interest rate on a loan and more complex derivatives such as “structured collars” which fixed interest rates within a band but introduced a degree of interest rate speculation. The investigation at Barclays revealed that some interest rates submissions reflected individual traders’ positions instead of the cost of interbank borrowing. However, its LIBOR submissions were relatively higher than in other banks during the credit crisis period which reflected appropriate management of structural risk, the risk that it may not be possible to decrease administered savings rates in line with decreases in money market (LIBOR) rates, resulting in a margin squeeze where lending is LIBOR-based.

So, is it difficult to find candidates those could prevent mistakes in the future, candidates with integrated knowledge of financial products, business operations and risk management expertise and maybe the most important feature – clear understanding of the role of financial institutions in economy?

Lack of capital or capabilities?

After the massive warnings from credit rating agencies about the deteriorating creditworthiness of financial institutions and new suggestions for better capitalization and additional injections of liquidity to sustain stability, an open question remains whether additional capital can restore self-sustainability of financial sector. Moreover, during the past several years financial system became more vulnerable and less significant for recovery of economy.  Further shortages of funds simply remind that currently held capital is not enough to fulfil all desires.

Spain's credit rating was downgraded by Fitch from A to BBB in 7 June and 28 Spanish banks’ credit ratings were downgraded by Moody in 25 June. The yield on 10 year Spanish government bonds increased above 6.5% and independent auditors revealed that Spain’s banks need 62bn euro support. Worsen situation caused Spain to ask officially support on Monday. The next country which possibly will need bailout is Cyprus. Fitch downgraded the country's credit rating to BB+ from BBB- and it could potentially require 4bn euro to recapitalize its banks, heavily exposed to the Greek economy.

As a response to the prevailing negative outlook, a proposal Towards a Genuine Economic and Monetary Union was introduced by President of the European Council, Herman Van Rompuy on Tuesday, 26 June. The plans for further banking, fiscal, and economic union could meet a tough opposition at EU summit on Thursday and Friday, 28-29 June. Angela Merkel refused to accept common liability and to introduce eurobonds.

So, could political union be sustained by sharing and implementing the best practices those strengthen banking system, enhance fiscal discipline and develop economic potential? Moreover, will EU’s leaders stick to the additional capital needs and common  debt of euro zone countries - eurobonds; or will the debate turn towards measures those enhance capabilities to contract in at least painful way and enforce recovery with a new strength.

How easily euro could be broken?

Central banks of the world’s major economies prepared contingency plans to stabilise markets in case anti-austerity parties won elections in Greece on Sunday, June 17. Moreover, leaders of the G20 meet in Mexico on Monday, June 18 to discuss Europe’s debt crisis and clarify contributions to the pledged IMF‘s fund worth of $430 billion US.  It is expected that additional cash injections into the financial system may calm public panic; however, could euro, the second largest reserve currency, be broken easily?

Prolonged political tensions in Greece intensified considerations whether it is able to meet bailout obligations. Moreover, it was announced that in the middle of May the ECB stopped providing liquidity to some Greek banks because of insufficient capitalization, overseas banks reduced reserves holdings in euro and Greeks rushed to withdraw money from domestic banks or transfer deposits to more stable ones. Euro deterioration to 1.24 against US Dollar last week and international mistrust in European currency strengthen the worst scenario – the end of euro.

It could be interesting to observe how European banks follow the news of deteriorating assets. Euro might collapse if European banks hurry to stabilize deteriorating assets by ridding of devaluated euro. However, the other scenario is also possible. Self market regulation mechanism may come into force and European currency may survive as long as European goods are traded in euro.