How to limit the ECB’s OMT?

Harald Benink, Harry Huizinga 12 July 2013

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Speaking about the Outright Monetary Transactions (OMT) facility during a recent press conference Mario Draghi, ECB President, said that “frankly, when you look at the data, it’s really very hard not to state that OMT has been probably the most successful monetary policy measure undertaken in recent times” (Draghi 2013). It is true that the launch of the OMT facility caused yields on the long-term sovereign debts of Italy and Spain to decline from their previous highs above 7% to around 4.5% now. And, until now at least, the euro has been preserved.

Still, we think that there are reasons to moderate Mr Draghi’s upbeat assessment. Actually, his bold statement last year of “doing whatever it takes to preserve the euro” and the subsequent announcement of the OMT facility may even have worsened the economic outlook and postponed an economic turnaround in several Eurozone countries. The statement alleviated immediate capital-market pressures on peripheral countries, thereby taking away the urgency for these countries to undertake structural economic reforms that are necessary to make their economies more competitive. Without such reforms, economic growth will not restart, and the buildup of sovereign debt will become unsustainable.

The ECB has indicated that – through OMT – it is willing to purchase unlimited quantities of government debt, with maturities between one and three years. Beyond this, the ECB has provided little detail on what the scale and scope of OMT would be in practice.

In our view, the ECB should indeed be willing to provide an unlimited amount of liquidity to troubled Eurozone countries, but only if the purpose is to prevent a shut-down of crucial government and banking sectors. In line with this, the ECB should now stipulate that liquidity, as provided through OMT, is not used to service longer-term debt, with maturities beyond three years. This qualification of the OMT facility ensures that basic solvency risk continues to be borne by private investors and that market discipline through long-term debt yields is restored.

OMT should neither be scrapped nor be limitless

By creating OMT, the ECB has acknowledged that Eurozone governments need a lender of last resort. As discussed by Wyplosz (2012), only the central bank is able to provide sufficient funding quickly enough to deal with a major public-finance contingency that might be caused, for instance, by a banking crisis. In the Eurozone, the European Stability Mechanism – with a maximum lending capacity of €500 billion – cannot be a substitute.
OMT purchases of government debt, although large, cannot be truly unlimited.1 The prospect of unlimited government-debt purchases by the ECB would eliminate all capital market discipline on borrowing countries, enabling them to expand borrowing at artificially low interest rates that do not reflect insolvency risk.2 The Bank for International Settlements (2013) recently argued that very low interest rates may lead countries to postpone structural reforms. This lowers growth prospects, further increasing the chance that debt becomes unsustainable.

In a recent testimony before the German constitutional court, Mr Asmussen (2013), member of the Governing Council of the ECB, alluded to the possibility of imposing restrictions on OMT. Referring to how member states could possibly try to ‘game’ OMT, he said, “[i]f for instance a state would convert all its bond issues to a maturity from one to three years, then we would react to that”.

A rule for limiting OMT

In our view, the OMT facility should be restricted to enable countries to raise just enough funds to keep crucial government and banking sectors afloat, regardless of whether a country’s inability to achieve this without OMT reflects a random breakdown of government funding (analogously to a bank run), or underlying insolvency. Regardless, OMT will ensure that the economy remains in the ‘good’ equilibrium where a collapse of the economy due to illiquidity is precluded. To keep the economy in this ‘good’ situation, a country needs to obtain net funding – through government-debt markets – equal to the excess of current expenditures over current revenues, plus the cost of stabilising the banking sector, if any.

OMT will serve the purpose of stabilising the prices of government debt with maturities in the one to three years range, thereby enabling countries to issue additional debt with maturities in this range. The issuance of additional short-term debt – on an annual basis – should, thus, be restricted to enable a country to exactly meet its net funding needed to keep its government and banking sectors liquid.3 Importantly, a country should be prevented from floating debt with maturities in the ‘protected’ one to three years range so as to service longer-term debt. This restriction effectively makes long-term debt subordinated to short-term debt.4 A country that wishes to service its long-term debt, therefore, can only do so by issuing new long-term debt.

Long-term debt issuance is only possible, if private investors consider a country to be solvent. When assessing solvency, investors will take into account that OMT-facilitated funding ensures that the country remains in the ‘good’ equilibrium where an economic collapse due to illiquidity is prevented. A country that is considered insolvent all the same will have to restructure its long-term debt to reduce it to a sustainable level.5

The precedent of the Greek debt restructuring of 2012

In March 2012, Greece restructured all of its outstanding government bonds, causing significant losses to private investors. Treasury bills, however, were excluded from the restructuring. Investors correctly anticipated this, enabling the Greek government to continue issuing Treasury bills with yields between 4% and 5% on a regular basis.6 This guaranteed some liquidity for the Greek government throughout the crisis. The Greek experience of excluding Treasury bills from a debt restructuring provides an important precedent for excluding short-term debts from future restructurings in the Eurozone.7

Markets expect long-term debt subordination

During the summer of 2012, there were several announcements by the EU Council and the ECB that, step by step, spelled out the nature of OMT. The last of these was the announcement on 6 September of the main parameters of OMT as we know them now. Angeloni (2012) shows that these announcements materially affected the shape of the yield curves of Spain and Italy, particularly reducing yields on debts with maturities in the one to three years range. Her analysis for Italy is reproduced as Figure 1. The relatively large decline in short-term yields is evidence of market expectation of some degree of subordination of long-term debt.

Figure 1. The impact of OMT-related announcements in 2012 on the Italian yield curve

Source: Angeloni (2012).

Concluding remarks

Mr Draghi now needs to clarify his earlier statement that he will do “whatever it takes” to save the euro. This statement was made at the height of the Eurozone debt crisis. A bold and unqualified statement may indeed have been necessary at that time to stop an arguably unjustified run by investors on peripheral country sovereign debt. To rectify this, the ECB should clarify that it will do whatever it takes, but not more than necessary, to save the euro. This means that the ECB should be ready to provide Eurozone countries with OMT financing to cover their current expenditures, but not to pay off all long-term debt holders. In this way, capital-market discipline and incentives for implementing economic reforms are maintained. Without such a clarification the ECB may become responsible for postponing an appropriate solution of the Eurozone crisis, possibly risking a new round of escalation with severe consequences.

Editor’s Note: An earlier, less technical version of this article was published in Handelsblatt (Germany) on 28 June, 2013 and in Het Financieele Dagblad (Netherlands) on 5 July, 2013.

References

Angeloni, C (2012), “The Bond Market Consequences of Mr Draghi”, Bruegel, Brussels.

Asmussen, J (2013), “Enleitende Stellungnahme der EZB in dem Verfahren vor dem Bundesverfassungsgericht”, European Central Bank, Frankfurt.

Bank for International Settlements (2013), Annual Report, Basel.

Benink, H and C Wihlborg (2002), “The New Basel Capital Accord: Making It Effective with Stronger Market Discipline”, European Financial Management 8, 103-115.

Demirgüç-Kunt, A and H Huizinga (2004), “Market Discipline and Deposit Insurance”, Journal of Monetary Economics 51, 375-399.

Draghi, M (2013), “Introductory statement to the press conference (with Q&A)”, speech, Frankfurt am Main, 6 June.

Evanoff, D D and L Wall (2000), “Subordinated Debt as Bank Capital: A Proposal for Regulatory Reform,” Economic Perspectives 24, 40-53.

Giavazzi F, R Portes, B Weder di Mauro, and C Wyplosz (2013), “The Wisdom of Karlsruhe: The OMT Court Case Should Be Dismissed”, VoxEU.org, 12 June.

Wyplosz, C (2012), “On Banking Union, Speak the Truth”, VoxEU.org, 17 September.


1 Drawing the parallel between deposit insurance and OMT guarantees, Giavazzi et al. (2013) argue that OMT should be unlimited to prevent a breakdown in required government funding. This may be sufficient but not necessary.

2 As related to bank regulation, Demirgüç-Kunt and Huizinga (2004) find that larger deposit insurance coverage tends to reduce bank funding costs.

3 The presumption is that governments stay current on their short-term debt, which implies that they should also be able to issue additional short-term debt to finance the interest cost of outstanding short-term debt. This discussion abstracts from the fact that over time long-term debt will become short-term debt as remaining maturity shortens. Note that this scheme takes away the need for a country to issue its own currency (and leave the Eurozone) to obtain essential liquidity, thereby reducing ‘redenomination risk’ as a stated purpose of OMT.

4 Evanoff and Wall (2000) and Benink and Wihlborg (2002) discuss how subordinated debt issued by banks can be useful in bank regulation. Subordinated debt improves market discipline on banks and it reduces the potential liability of the deposit-insurance agency.

5 The market’s assessment of a country’s solvency should be as good as the ECB’s, and hence the ECB (or any other official lending agency) should not step in to provide additional funding so as to prevent (or postpone) restructuring, as this only serves to transfer solvency risk from private investors to the ECB and ultimately all Eurozone taxpayers.

6 For instance, on January 10 2012 Greece auctioned €1.25 billion of Treasury bills with a maturity of six months and an annualized yield of 4.9%. See the website of Greece’s Public Debt Management Agency at http://www.pdma.gr/index.php/en/.

7 In the Greek case, substantial official loans were made available through the EFSF. For a major Eurozone country, proportionately less money is likely to be available through the ESM, increasing the need to raise more money through short-term debt issuance. This could explain why OMT covers government debt in the wider majority range of 1-3 years – implying deeper capital markets – rather than simply Treasury bills.

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Topics:  Europe's nations and regions

Tags:  Eurozone crisis, banking union, OMT

Professor of Banking and Finance and Fellow of the Centre for Economic Research (CentER), Tilburg University

Professor of Economics and Chairman of the European Banking Centre, Tilburg University

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