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Analysis
Modest programme of euro bond purchases

Modest programme of euro bond purchases

Spain must adopt rescue package
Less Bundesbank-ECB divergence than meets the eye

by David Marsh

Tue 28 Aug 2012

The European Central Bank is inching towards a finely-calibrated and probably rather modest government bond purchase programme that will not by itself ‘rescue the euro’ but will maintain the central bank’s credentials as an inflation-fighting central bank presiding over a stable currency.

The planned action, to be discussed at next week’s policy meeting of the ECB governing council, places the onus on troubled governments – above all Spain – to make a formal application for aid from the European Financial Stability Facility (EFSF) and the permanent European Stability Mechanism (ESM).

This need for a decisive trigger from hard-pressed euro countries is bracketed with the related requirement that the ECB acts independently of governments. These two sensitive conditions are important reasons why the action is likely to be more limited than initially suggested by many market participants after ECB president Mario Draghi’s ‘do what it takes to preserve the euro’ statement in London on 26 July.

The Spanish government, wary of what it regards as the humiliation of making a formal bid for European assistance, seems in no hurry to apply. It appears to be using the fall in bond market yields since Draghi’s statement as an excuse for delay. This raises the risk of a renewed stand-off and fresh bond market nervousness, since the ECB will not ‘pre-commit’ unless Spain moves first.

The ECB’s planned bond buying, which would be in tandem with purchases of longer-dated bonds by the EFSF and ESM on the primary and/or secondary markets, would be designed to provide a market environment promoting further declining yields for Spanish and Italian debt. The aim is for the ECB to catalyse a return to bond buying by international and European private and public sector investors, independently of what happens on the vexed question of Greece’s euro adherence. A relatively small volume of ECB purchases would be seen as a success, especially as it would alleviate well-publicised German worries about balance sheet risks at the ECB and its constituent central banks.

The ECB has been somewhat surprised by market reaction to Draghi’s statement at a London conference organised by the UK government to showcase the Olympic Games. His address was crafted from speaking notes for an ‘armchair discussion’ rather than from a firm script for a formal speech. Although it employed previously-used words and formulations, the statement was not discussed in advance with colleagues. On the other hand, the Draghi message is seen in Frankfurt as a helpful contribution to unblocking a debate about what the ECB can and cannot do with bond purchases.

In the battle over the euro, the ECB is far from speaking with one voice. However, there seems to be more convergence than many believe between Draghi and Jens Weidmann, the tough-talking Bundesbank president who confirmed his aversion to government bond purchases in a weekend interview with Der Spiegel magazine.

Weidmann’s publicly-stated anti-bond buying criticism on the one hand symbolises growing polarisation and personalisation of the ECB policy debate. ‘In a democracy, such a far-reaching mutualisation of risks should be decided by parliaments and not by central banks,’ he said. ‘We should not understate the danger that central bank financing can lead to addiction like a drug.’ In similar vein, former ECB executive board member Jürgen Stark, who resigned last year after a dispute over bond purchases, says in a commentary in today’s Handelsblatt newspaper that the planned ECB role in euro crisis management would overburden its capacity, reduce its independence and ultimately lead to higher inflation.

On the other hand, Weidmann’s and Stark’s objections – while provoking some irritation at the ECB – give Draghi useful protection from Spanish and Italian politicians’ calls for unlimited, unconditional ECB bond market intervention. Likewise, media speculation of a rift between Chancellor Angela Merkel and Weidmann, who previously worked for five years as her chief economic policy adviser before he moved to Frankfurt last year, is wide of the mark. It is pointed out in Frankfurt how Merkel referred approvingly to Weidmann’s bond market warnings in a German TV interview on Sunday.

Weidmann repeated his criticism of bond purchases partly in reaction to exaggerated reports that he was completely isolated at the ECB’s last policy meeting on 2 August, where – contrary to the impression given by the ECB itself – no formal vote was taken on any measures. A perception of deep divisions on the ECB council has been intensified by media reports that the ECB is likely to introduce formal ceilings for bond yields or spreads, which would be anathema to Germany. The facts are different. It is pointed out that central bank bond dealers would naturally adopt trading bands on buying and selling, but these could change several times a day, would not be made public and would certainly not be formal ‘target zones’.

Even if the ECB goes ahead with bond purchases, Weidmann will have played a role in reinforcing the ECB’s existing intentions to ensure that governments and not the central bank take the lead in euro underpinning. By signalling he will maintain a constant drumbeat of scepticism over any future bond programme, the Bundesbank president has increased the requirement for the ECB and governments to demonstrate that such buying will achieve desirable results. Additionally, he fulfils a modern need for greater transparency over central banks’ manoeuvring, coining the phrase that ‘the ECB council is not a Politburo’.

One result of Weidmann’s campaign, backed by an increasingly active and sophisticated Bundesbank communications strategy, could be to introduce legal safeguards ensuring that potential financial losses resulting from any ECB bond purchases are spread more widely among debtor as well as creditor central banks and governments in Europe. At present the Bundesbank is liable for 27% of any costs arising from bond market intervention, for example through write-downs of ECB government bond holdings.

In view of Weidmann’s frequent opposition to bond purchases, and the widespread belief that they will go ahead anyway, the Bundesbank president is under pressure from some quarters to consider resigning if such a programme takes place in coming weeks. He is very unlikely to do this. All the previous Bundesbank leaders who resigned for different reasons in the past two decades – Karl Otto Pöhl in 1991, Ernst Welteke in 2004, Axel Weber in 2011 and, again last year, Jürgen Stark (a former deputy Bundesbank president ) – did so after at least five years in top positions. If he quit over the next 12 months, Weidmann, 44, who has given every sign of building a solid legacy at the Bundesbank, would go down in history as the central bank’s shortest-serving president – something he would be highly unlikely to countenance.

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