February 26, 2013 5:53 pm

Fears ECB bond scheme has its weakness

When the European Central Bank unveiled its new programme to buy eurozone bonds last September, EU officials were quick to tout its differences from previous schemes: It would not only be unlimited, but also conditional on a struggling country living up to Brussels-mandated economic reforms.

In the wake of this week’s chaotic Italian elections, some investors and analysts are now concerned that such strings, once hailed as the programme’s strength, may in fact be its Achilles heel.

With a long and potentially unstable period ahead for Rome as it attempts to cobble together a new government, Italy may be without the kind of credible policy decisions that are preconditions to gaining access to ECB assistance.

“The ECB has pledged to cut off the tail risk of a eurozone implosion with the [bond-buying programme], but it is not an Anglo-Saxon bank and it will want to have a focus on conditionality,” said Andrew Balls, European managing director for Pimco, the world’s largest bond fund. “The gridlock in Italy is a reminder of the political obstacles to stabilisation of the eurozone.”

It is hard to overstate the importance the ECB bond-buying programme, known as Outright Monetary Transactions, has had on the three-year-old crisis.

Within EU policy circles, it is widely accepted that OMT was the most important element in stopping the panicked flight from the eurozone’s periphery last year, a turning point many believed had finally ended the crisis’ acute phase.

By pushing the programme through despite opposition from Germany’s powerful central bank, many officials believed ECB chief Mario Draghi had finally given the eurozone the “bazooka” it long needed: the central bank’s printing presses. Investors no longer had reason to fear their holdings would default or lack for buyers.

But Mr Draghi has long been clear about the strings attached.

Before the ECB buys a single bond of a country in trouble, its government must first submit to a programme designed by the eurozone’s €500bn rescue fund, the European Stability Mechanism, “which envisages strict and effective conditionality spanning the fiscal, macroeconomic, structural and financial spheres,” as Benoît Cœuré, ECB executive board member, put it in a September speech.

Those are exactly the sort of conditions Italy’s voters rejected in this week’s election and that a weak government, which could include overtly anti-austerity parties led by either former prime minister Silvio Berlusconi or populist outsider Beppe Grillo, would be loathe to enforce.

“Concern is growing in capitals and the markets as the much lauded ESM-OMT formula cannot work without a stable government in place,” said Mujtaba Rahman, a Europe analyst at the Eurasia Group risk consultancy. “And given the electoral numbers, that looks unlikely.”

Eurozone officials cautioned that while Italian and other peripheral eurozone bonds sold off heavily Tuesday, they were nowhere near levels where OMT would have to be triggered.

“Let’s let the dust settle first before rushing to far-reaching conclusions,” said one senior official involved in crisis-fighting. Another said he felt “the same as Zhou Enlai [did famously about the 1789 French revolution]: Too early to tell”.

Still, other officials were privately concerned the post-election tumult had returned market focus on how much OMT, and with it the eurozone’s future, was not in the hands of central bankers but rather in the same politicians with a shaky record with financial markets.

“If Italy is paralysed, this does not only affect possible programmes, but the entire domestic political process as well,” said a eurozone finance ministry official.

For its part, the ECB has been so explicit about the need for the fiscal conditions attached to OMT that it would be difficult to justify deploying the programme without securing a pledge of fiscal rigour from an Italian government.

“If you take the view that because of Italy’s size it might be willing to test the ECB’s resolve ... and, for whatever reason, the ECB declines to get involved, there’s a risk that that [OMT] backstop doesn’t work in the way people hoped,” said Ben May, economist at Capital Economics.

Moreover, the fiscal conditions linked to OMT were designed after the ECB’s painful first experience of its old bond-buying programme, the so-called Securities Markets Programme.

Figures released just last week showed that of the €208bn the ECB deployed on SMP, by far the greatest share – €99bn – went towards buying Italian debt at a time when Mr Berlusconi, as prime minister, was failing to implement structural reforms explicitly detailed by Jean-Claude Trichet, then-ECB president.

While EU officials on Tuesday said they accepted the democratic verdict in Italy, several also emphasised the importance to a future Italian government living up to EU-mandated commitments – a precondition for a future OMT programme – though the direct tie to any future assistance was not explicitly mentioned.

“We think those reforms were indispensable for the Italian economy,” Olivier Bailly, a European Commission spokesman, said of policies implemented by Mario Monti, outgoing technocratic prime minister. “These are Italian commitments which remain in force and the Commission expects Italy to meet its commitments.”

Jeroen Dijsselbloem, the Dutch finance minister who heads the eurogroup of finance ministers, added: “I hope that Italy is aware that it also bears responsibility for stability in the eurozone as a whole ... Whoever [the new government] is, Italy must hold to European agreements.”

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