Spain and Italy mustn’t blow ECB plan
The European Central Bank‚Äôs bond-buying scheme has bought Spain and Italy time to stabilise their finances. But if they drag their heels, the market will sniff them out. It will then be almost impossible to come up with another scheme to rescue the euro zone‚Äôs two large problem children and, with them, the single currency.
Mario Draghi‚Äôs promise in late July to do ‚Äúwhatever it takes‚ÄĚ to preserve the euro has already had a dramatic impact on Madrid‚Äôs and Rome‚Äôs borrowing costs. Ten-year bond yields, which peaked at 7.6 percent and 6.6 percent respectively a few days before the ECB president made his first comments, had collapsed to 5.7 percent and 5.1 percent on Sept. 7.
Most of the decline came before Draghi spelt out last Thursday the details of how the plan will work. What makes the scheme powerful is that the ECB has not set any cap to the amount of sovereign bonds it will buy in the market. The central bank‚Äôs financial firepower is theoretically unlimited, whereas the euro zone governments‚Äô own bailout funds do not have enough money to rescue both Spain and Italy.
But the new type of intervention, christened ‚ÄúOutright Monetary Transactions‚ÄĚ, has three important limitations.
First, the ECB will only buy a country‚Äôs bonds if its government agrees to a bailout programme with the euro zone, and sticks to ‚Äústrict and effective‚ÄĚ conditions detailed in such a deal. Second, the central bank will focus its purchases on bonds with a maturity of one to three years. Finally, Draghi has not specified how much he wants to drive down Madrid‚Äôs and Rome‚Äôs borrowing costs.
This fine print makes sense. But it also means that there is no free lunch. While the ECB seems unlikely to dream up new economic reforms for Spain and Italy, it will probably want their governments to put more precise time frames around what they are already supposed to be doing. The involvement of the International Monetary Fund, which has a somewhat unfounded reputation as a bogeyman, will also be sought. No wonder neither Spain‚Äôs Mariano Rajoy nor Italy‚Äôs Mario Monti is rushing to take advantage of the scheme.
Meanwhile, the ECB‚Äôs focus on short-term bonds means that Madrid and Rome would have to find some other way of issuing long-term debt – which accounts for 66 percent and 62 percent of outstanding debt respectively. If they lost access to the markets, the zone‚Äôs bailout funds would have to ride to the rescue. But they still wouldn‚Äôt have enough money for both countries.
What‚Äôs more, Spain‚Äôs and Italy‚Äôs borrowing costs are still too high for comfort. The ECB‚Äôs main justification for bond-buying is that investors are unfairly punishing them because of fears that the euro will break up. But it also recognises that the spread between their bond yields and Germany‚Äôs 1.5 percent 10-year borrowing costs is only partly due to such ‚Äúconvertibility risk‚ÄĚ. It is also because of bad economic policies.
While there aren‚Äôt any scientific measures of convertibility risk, it seems like the bulk of it has disappeared since Draghi‚Äôs comments in late July. A reasonable guesstimate is that the risk of euro breakup might still be inflating Spanish yields by 1 percentage point and Italian ones by perhaps 0.75 percentage points. If the ECB used those numbers to guide its bond-buying programme, 10-year borrowing costs would drop to 4.7 percent and 4.4 percent respectively. To fall further, the countries would need to take more action themselves.
Although investors are currently relatively bullish about Spain and Italy, they are notoriously fickle. Rajoy and Monti should remember how the good mood, engineered at the start of the year by the ECB‚Äôs 1 trillion euros of cheap long-term loans to the zone‚Äôs banks, vanished with the spring. What‚Äôs more, both are facing tougher political challenges than they did at the start of the year when they were enjoying their honeymoons as new prime ministers. Each of their economies has declined this year and will continue to do so next year – shrinking roughly 5 percent over the two-year period, according to Citigroup.
For all these reasons, it is vital that Rajoy and Monti don‚Äôt dawdle. Assuming the German constitutional court this week backs the creation of the European Stability Mechanism, the zone‚Äôs permanent bailout fund, the Spanish prime minister should apply immediately for a programme.
Italy, a rich country, should still be able to avoid a bailout. But to do so it needs to cut its public debt, ideally with a vigorous privatisation programme and the creation of a wealth tax. With elections due next April and no guarantee that an effective government can be formed thereafter, there is only a tiny window for action. Monti‚Äôs technocratic government needs to jump through it.
The ECB has put its credibility on the line with its new bond-buying plan. Germany‚Äôs central bank, the Bundesbank, has attacked it on the grounds that it has come close to breaking treaty provisions banning the ECB from bailing out governments. For now, Draghi can withstand the criticism, as long as Angela Merkel keeps backing him. But if Rajoy and Monti don‚Äôt move fast, the ECB‚Äôs magic will wear off. And if its medicine then fails, it will be hard to conjure up the political will for an even more powerful concoction.