ECB, OMT: Nuances and Fireflies
David R. Kotok
Cumberland Advisors, September 8, 2012
Outright Monetary Transactions (OMT) is the name of the newest program launched by the European Central Bank (ECB). If you haven’t read about it, if you don’t care about it, don’t waste any more time reading this commentary.
Nuance 1. The ECB now views sovereign debt instruments with three years left to maturity as cash equivalents. There is a reason behind this strange definition; we discuss it in Nuance number 2. Under OMT, a promise to pay you in euro banknotes three years from now is viewed as the same as the banknote today. The adjusting process is the nominal interest rate on the seasoned and market-trading note. That interest rate will be manipulated by the ECB to something lower than market forces would set. That manipulation will be performed by the central bank issuer of the banknotes. Technically, it will be implemented by the 17 national central banks (NCB) that make up the euro system. The nuance is in the direct admission of this concept. By declaring this policy Mario Draghi has moved the policy needle to the extreme left. The ECB will disregard the creditworthiness of the sovereign issuer. The ECB standard is already down to a BBB-level rating. The ECB has bent its rules many times. Investors must ask how this latest move ratchets up moral hazard. They must guess when and where the presumed increase in moral hazard risk will evidence itself.
Nuance 2. The ECB publicly commits to a parity claim with the private creditors. Here the ECB is admitting that the previous assertion of a senior claim in the case of the Greek default created unintended negative consequences which the ECB must now repair. In the case of Greece, the collective action clause retroactively changed the terms of a sovereign bond of Greece. The CAC was used to “stiff” the private-sector holders of Greek debt. Prior to that arrangement, the ECB had manipulated its creditor position to a senior status. The result was to widen the spreads on Spanish, Portuguese, and other weaker eurozone credits. Market agents concluded that the European powers would stiff them again if things deteriorated. With this OMT action of denying seniority, the ECB is trying to cure a “Fool me once, fool me twice” folly. An additional nuance here is that the forthcoming ESM rules state that, starting January 1, 2013, all eurozone sovereign debt issued with greater than one-year maturity will have identical collective action clauses. Thus the ECB is positioning in advance of that rule and trying to manipulate the specific market in advance of the ESM. That leads to nuance number 3.
Nuance 3. “Conditionality” is the new buzzword. It has replaced the previous ECB construct used with Greece. Greece deteriorated ahead of changes in ECB policy actions. In each tragic step of Greek restatement, credit downgrade, spread widening, etc., the ECB acted after the fact. It kept amending the rules to permit Greece more time for misbehavior. The cost of this moral hazard increase has been severe. ECB policy-making was backward-looking. With conditionality, the ECB will require a country to request assistance and thereupon submit to review, supervision, and agreed-upon austerity measures. The ECB says its purchases of weaker-credit, 3-year-maturity debt will occur only after the sovereign has requested help. This, too, is a new form of central banking. It changes the rules. Sovereigns now need to determine if they are going to submit to conditions that are externally imposed. They will try to pre-negotiate the outcome. Spain is the candidate under scrutiny now. Investors need to determine how they will position on this uncertainty. Does the promise of ECB intervention keep Spanish rates lower than they would otherwise be, thus enabling Spain to avoid conditionality? Or defer it? We shall see. Is there a future unintended consequence that is going to result in a market shock? An example is Spain waiting too long to make adjustments and reforms, then encountering an accelerating downward spiral in its economy. Note that Spanish banks have been bleeding from capital flight. The Spanish central bank is now using Emergency Liquidity Assistance (ELA) to prevent bank failures. That happened and continues to happen in Greece. We shall see.
Nuance 4. The Bundesbank publicly dissented to the new ECB program. Its president, Jens Weidmann, declared the ECB move “tantamount to financing governments by printing banknotes.” Germany has only one vote in the ECB governing council decision, but note that Germany is the largest “capital key” in the eurozone. It is 27% of the weight and therefore incurs 27% of the cost of any failed ECB action. France is second at 20%, Italy third at 18%, and Spain fourth at 12%. Also note that as a country gets into trouble and “requests” help, its share of the capital exposure to EFSF and ESM guarantees is reduced to zero. That is consistent. How can a Greece, which cannot pay, guarantee anything? So far Greece, Ireland, and Portugal are on this “zero” list. That leaves the other 14 eurozone members more exposed. The recalculation to date has raised Germany to 29%, while Spain is up to 12.75%. If Spain requests aid and drops to zero, the recalculation among the remaining 13 eurozone states will be large. Weidmann is rightfully worried.
Where does this lead?
We have labeled the European sovereign debt saga a “dance of the fireflies.” Why? Fireflies dance in the dark. They create a mosaic, an appearance. Turn on the headlights and they stop. The image you then see is much clearer. Turn off the headlights and they resume their alluring but unpredictable dance. Headlights are the metaphor for unencumbered market forces.
In Europe, we continue to witness this game of lights on and lights off. We watch moral hazard increase with each action. And we watch economies shrinking as countries avoid reforms, defer the reduction of expenditures, and impose higher taxes. The politicians are doing the reverse of what is needed to contain the crisis. Until they emphasize growth in the private sector, this downward spiral will continue. Europe is in recession, and it is getting worse.
The newest ECB program is another “can kick.” It may buy some time. It uses monetary policy to address fiscal problems. It may delude markets, as it did in the short-covering rally. The OMT lacks headlights that could be turned on to achieve clarity. That is revealed on close examination of the nuances. Jens Weidmann is correct.
In a recent (August 15, 2012) Cato working paper entitled “World Hyperinflations,” co-authors Steve Hanke and Nicholas Krus document 56 episodes of monetary policy running amuck. The first was in France in 1795-6. Germany was 1922-3. Greece was 1941-5. About 40% of the episodes were in Europe.
Jens Weidmann knows his history.
David R. Kotok, Chairman and Chief Investment Officer of Cumberland Advisors