Words ought to be a little wild, for they are the assault of thoughts on the unthinking
- J.M. Keynes

Wednesday, 5 September 2012

Draghi about to unveil "new" old plan?

Tomorrow is D-Day. The leaking ship that is the European Union has so far caused the market to be hopeful and upbeat.

Today’s scoop which caused a sharp reversal in EUR/USD and other risk assets was the Bloomberg article “ECB Plan Said To Pledge Unlimited, Sterilized Bond-Buying

This quote from the article sums up the current logic-free market [emphasis mine]:
“For the moment, the focus really is on the word ‘unlimited,’ which, if indeed affirmed by Draghi at tomorrow’s meeting, would constitute a new step in the ECB’s rhetoric,” said Thomas Costerg, an economist at Standard Chartered Bank in London. That would “send a powerful signal to the market.

First, are investors going to risk their capital based on rhetoric? (Don’t answer that, it’s rhetorical)

Second, ‘unlimited, sterilised’ is an oxymoron. Sterilisation of bond purchases introduces a limit to the amount of purchases which can be made. Since sterilisation involves ECB withdrawing cash from the Eurozone banking system, it can only be done to the extent that Eurozone banks have excess cash. For example, consider the extreme case where Eurozone banks have no excess cash on the balance sheet. Then any selling of sovereign debt to the ECB by foreigners will lead to a sterilisation failure since the Eurozone banking system will not have cash/cash equivalent to put on deposit. Banks would have to sell assets on their balance sheet to free up cash to put up for ECB deposits. Even though we are not at such an extreme since banks have cash and are hoarding it due to uncertainty (but maybe not the Spanish), large scale bond buying is actually going to worsen the situation by causing further asset sales and cash hoarding by banks. Even if selling to the ECB is purely by Eurozone banks, the limit to purchases is the total amount of sovereign bonds held by the Eurozone banking system. 

In any case ECB intervention will not solve anything unless net cash holdings left after sterilisation are used to buy new issuance of sovereign bonds. However since net cash holding remains the same before and after purchase due to sterilisation, success depends on the cash being redistributed to willing buyers. Or those who have currently have cash changing their mind about buying peripheral sovereign debt. The latter is unlikely to happen unless holders of cash are swayed by "new" rhetoric. Willing buyers would likely be domestic banks which leads to strengthening of the vicious sovereign-banking loop. A most unfortunate unintended consequence. 

In the end, ECB intervention will only transfer credit risk from commercial banks and private investors to the central bank, in effect a backdoor bailout. Moreover, as pointed out above, it will enable non-peripheral European banks to dump their peripheral holdings and further withdraw from the periphery. A result contrary to what Draghi hopes to achieve. Indeed, data on rising domestic holdings of sovereign debt in the periphery despite SMP show that ECB bond market purchases lead to foreigners and non-domestic (i.e. non-peripheral) banks to exit first.

Third, is it really a “new step” since the SMP is (was?) also ‘unlimited’ without any cap on purchases? Further, the SMP after buying in excess of €200bn (standing at €209bn currently) was unable to have any significant lasting effect on bond yields or on crisis resolution. 

Fourth, in all other aspects too it seems to be no different from the SMP. The plan according to Bloomberg and FT will:
  1. Not have any public cap on yields – Same as SMP
  2. Only focus on government bonds – Same as SMP
  3. Target short-dated maturities of upto 3 years – Subset of SMP
  4. Drop preferred creditor status – SMP never had explicit preferred creditor status either. And Europe has shown that in a crisis promises and law cannot be trusted as reliable guides to future conduct. It is highly unlikely that the ECB voluntarily submits to an equal haircut when a peripheral default threatens to wipe off its capital. Of course this ‘pari passu’ pledge is made with the assumption that such a scenario cannot happen. This is the same hubris we’ve seen so far: ‘We have no plan B because our plan A will work’. Since 2010 this has resulted in one half-witted plan A after another.
So Draghi, after all his blustering, is just going to re-announce the SMP. Rather, just announce the resumption of the SMP by another name. What springs to mind is not “bazooka” but “Bashi Bazouk” (quoting Captain Haddock).

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