Friday, 14 June 2013

To buy or not to buy...

...that is the question. More accurately the question confronting the German Constitutional Court is: does the ECB have the right to buy peripheral European bonds? A scan of the constitution’s text[1] suggests that the decision is not clear cut. Essentially under any reasonable interpretation it could be argued that a number of recent trans-Eurozone programmes are probably not compliant with German law. Whether the Constitutional Court has the power has the power to do anything about it is, however, debatable.

The constitution rather reasonably insists that the Bundestag (German parliament) has oversight and, ultimately, control over the Federal Republic’s purse strings. Recent crisis-fighting measures, however, are difficult to reconcile with this requirement. The instruments in question are the European Stability Mechanism (ESM) and, to a much more meaningful extent, the Outright Monetary Transactions (OMT). The ESM is an organisation which has lending capacity of up to €500bn to provide financial assistance to member states. Essentially it is the permanent bailout fund of the Eurozone.

The OMT is a monetary instrument designed to ensure the convertibility of the euro (so that the euro remains a viable single currency throughout the current eurozone membership). It would do so by buying secondary market bonds of fiscally challenged member states on the ECB’s own balance sheet. Both of these programmes have the potential to lose German taxpayers’ money. For the ESM the money and risks are real. As far as the OMT is concerned, given that bottomless pockets are a feature of a really effective central bank, is there any real concern?

“Within our mandate, the ECB is ready to do whatever it takes to preserve the euro. And, believe me, it will be enough.”
Mario Draghi, ECB President, 26 July 2012 

The risk that the ECB might print money and then lose it through investments in peripheral European debt markets might seem abstract. If losses were realised, however, they would need to be reflected on the ECB balance sheet and would deplete its capital thereby requiring new capital injections from member states. As the purchases are unlimited, meaning the potential losses are unlimited, the capital injections would therefore be theoretically unlimited.

There are also the usual German concerns about state financing of monetary transactions and bailouts, both of which are explicitly forbidden under the European treaties.

“Overdraft facilities or any other type of credit facility with the European Central favour of Union institutions...or public undertakings of Member States shall be prohibited, as shall the purchase directly from them by the European Central Bank or national central banks of debt instruments.”
Article 123, Treaty on the Functioning of the European Union 

This is serious because Mr Draghi rightly describes the policy as “the most successful monetary policy that has been taken.” It has lowered the fiscal costs of countries attempting to restore their public finances, but goes far beyond the public sector. It has also acted as a genuine conduit for lower borrowing costs by reducing covered bond (securitised loan) and corporate borrowing costs. This has been the policy that keeps on giving and we believe it has been pivotal in pre-empting the improvement in recent eurozone data.
Source: Brewin Dolphin, Barcap
The court’s hearings began on Tuesday and continue Wednesday but a decision is not expected before the autumn. Jens Weidmann of the Bundesbank criticised the programme for blurring the boundaries between monetary policy and fiscal policy. His view was countered by Germany’s representative on the ECB’s executive board, Jorg Asmussen who asserted that the risk of doing nothing (i.e. not announcing the OMT) were too great. We certainly believe the risk of losses to taxpayers is reduced following the announcement of the OMT creating an element of perversity to the overall case.

You’re asking the wrong guys!

There may also seem to be a touch of desperation in some of the case for the defence – such as you can’t sue against an act which doesn’t exist yet.

“The ECB’s announcement so far hasn’t been turned into a formal act, so you cannot sue against it yet,”
Ulrich Haede, Representing the German Government 

Most tellingly, however, the ECB falls under the influence of the European Supreme Court and therefore need not defer to the German Constitution. These would not be the first programmes which could theoretically inflict unlimited losses on German taxpayers. The Securities Markets Program (SMP) operated similarly to the OMT, the Long Term Refinancing Operations (LTRO) involve the ECB accepting collateral in return for advancing cash sums. In fact the Main Refinancing Operations (MRO) which underpin monetary policy in the eurozone could all potentially incur losses for the taxpayers even if the probability of loss drops rapidly with the more mainstream instruments.

Investors expect a qualified acceptance (so-called “yes…but”) by the Constitutional Court on the basis that this would echo their previous judgement that all bailout loans were acceptable provided they are approved by the Bundestag. However, the jurisdictional issues suggest that the Court might not feel able to make a judgement. We should be careful what we wish for as, were such a ruling to be released shortly before the September 22nd German election it could undermine support for the mainstream parties who are all broadly pro-European.

We can take some comfort form the fact that a restricted, or even prohibited, OMT does not necessarily plunge the eurozone back into crisis. While the OMT may have been the most successful monetary policy, the ban on naked sovereign credit default swap (CDS) exposure has been an unsung hero. A CDS contract allows investors to be compensated for losses suffered if the subject (in this case a sovereign state) defaults. The previous practise of buying insurance despite not holding any insurable assets has been compared to taking out insurance on your neighbours house and then burning it down. As such speculation against sovereign states is now more difficult. We list that as a positive when assessing the risks stemming from the eurozone.

[1] Basic Law for the Federal Republic of Germany,

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