Duncan’s Economic Blog

ECB Intervention is Failing

Posted in Uncategorized by duncanseconomicblog on August 11, 2011

Is ECB intervention in the Italian and Spanish bond markets working?

Since Monday the ECB has been buying Spanish and Italian debt in the secondary market aiming to drive down the yields and hence ensure that both countries can afford to borrow from the debt markets.

The yields on both countries’ debt had increased sharply in the preceding fortnight (post-the latest Eurozone crisis summit) in a pattern which has become strangely familiar over the past year – the yield hits 6%, the country denies there is a problem, it hits 6.5%, more denials and suddenly it is at 7% and a ‘bailout’ is being arranged.

Whilst Ireland, Portugal and Greece represent 4.5% of EU GDP between them, Spain is 8.7% alone and Italy is 12.7%. They are too big to fail –  but also possibly too big to bailout.

If Italy and/or Spain were to require a bailout they would obviously not be able to participate in the EFSF – at which point the increased costs to France (in particular) would become perhaps insurmountable. In other words if one of these two go, the whole crisis coping mechanism goes with it. (Not to mention the fall out in the banking sector).

So – back to the original question, is the ECB intervention working?

As the yield demanded by investors has fallen from well over 6% to around 5% in both cases, it may appear so.

But in the CDS market (credit default insurance) a different picture emerges – one of continuing and rising concern for Spain and Italy.

This matters.

If the markets were genuinely reassured we would expect CDS rates and bond yields to fall together. As CDS rates (where, crucially the ECB is not intervening) are continuing to rise this looks like entirely artificial price moves in the bond market caused by the ECB acting as buyer of last resort.

The question becomes – what happens when the ECB stops buying? The answer may be a swift return in bond yields to uncomfortably high levels.

So – why can’t the ECB just continue buying? Well it could. But it would soon own a substantial proportion of outstanding Italian and Spanish government debt – something which Northern European tax payers are unlikely to be happy about and a situation which may be sustainable. What will it do to confidence if an international central bank (with no power of taxation) is standing behind a substantial segment of the debt of two major economies?

Once more it looks like the Eurozone’s ‘solution’ is just an attempt to buy time – let’s hope they use this time well.

10 Responses

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  1. Dave Holden said, on August 11, 2011 at 9:52 am

    Given recent questioning of France’s AAA rating If it continues buying without success couldn’t we end up with Germany backstopping the whole of the rest of Europe.

  2. JakeS said, on August 11, 2011 at 12:10 pm

    “But in the CDS market (credit default insurance) a different picture emerges – one of continuing and rising concern for Spain and Italy.

    This matters.”

    Not necessarily. What’s the volume, and are these casino side bets or genuine hedges? Those distinctions matter, and we do not know them because credit default swaps are poorly regulated.

    “Given recent questioning of France’s AAA rating If it continues buying without success couldn’t we end up with Germany backstopping the whole of the rest of Europe.”

    Germany, Finland, the Netherlands. In other words, the members with internal current accounts surpluses. The underlying problem is that the internal current accounts imbalances are unsustainably large. There is no medium-term solution, let alone a long-term one, unless these imbalances are addressed on both the surplus and the deficit side.

    The inclusion of internal deficit countries in these three- and four-letter agencies has always been political theatre to conceal the fact from the internal surplus countries’ voters. They have been treated to twenty years of Austerity, so anybody who comes right out and tells them that the mercantilist CA surpluses this Austerity secured will have to be surrendered will become politically radioactive. Hence the desperation among the surplus countries’ Very Serious People to make the deficit countries shoulder the full burden of maintaining the exchange rate peg.

    Just a pity that a currency union that relies on the internal deficit countries to defend its exchange rate regime is inherently unstable.

    – Jake

    • duncanseconomicblog said, on August 11, 2011 at 12:14 pm

      Fair point on CDS vols – although anecdotally they are very high at the moment.

      Agree entirely on the CA issue – I’ve suggested before the Eurozone needs some regional form of Keynes’ proposed International Clearing Union which means adjustment comes on both sides.

      • JakeS said, on August 12, 2011 at 12:17 pm

        But absent proper regulation of credit default swaps, we don’t know whether the CDS spreads are a sign that real bondholders want to hedge a default or that gamblers have flooded the money markets (not like that has ever happened before – perish the thought).

        Another possible interpretation of the rising bond prices and rising CDS spreads is that the bondholders are holding their bonds in their investment portfolios rather than their trading portfolios. Since the bonds still trade substantially below their hold-to-maturity value in the no-default scenario, bondholders may want to buy credit default swaps instead of realising accounting losses from selling the bonds in the secondary market. Given that CDS contracts are, as I understand it, typically structured with a series of small payments (as opposed to the instant capital loss from selling below the book value), this option would be particularly attractive for thinly capitalised institutions.

        In other words, you may be looking at a case of quote-unquote “regulatory arbitrage.”

        Or it might be about diversifying the *political* risk. Somebody over at European Tribune dug out some numbers that implied that American banks were selling most of these CDS contracts. By buying CDS contracts from American institutions, the European bondholders open the option of going to Uncle Sam for a bailout (by proxy, through the threat of wrecking what’s left of the US financial sector) if Merkel fails to bail them out through the acronym agencies (or, for that matter, a more direct handout).

        My overarching point being that given the present state of regulation of credit default swaps, and the political power of the remaining private holders of deficit €-zone sovereigns’ bonds, the CDS spreads actually say very little about anything more interesting than the odds at Churchill Downs.

        – Jake

        • Jomiku said, on August 12, 2011 at 5:36 pm

          I think it’s just as likely that spreads are rising because counter-party risk has increased. You can buy coverage but it may not pay. This means coverage with less counter-party risk is worth more, so it costs more. Would you trust a Eurozone bank to make good if the problem is sovereign debt rollover? If I were that bank’s country, I’d wipe those debts out on takeover and/or sale.

          I’m not sure what happens. We do seem to be approaching the point where the main creditor nations are going to have to make a decision about which loss they’ll take.

          As an aside, can you imagine what an Augustus would do with this kind of leverage? He’d take a much greater degree of effective control over function. I mention Augustus because he was not merely power mad but was trying to spread the Roman way to the barbarians. He’d see this as an opportunity to make change happen.

          • JakeS said, on August 12, 2011 at 5:44 pm

            It is difficult to imagine the Troika obtaining greater control than they have already been conceded. They are rapidly approaching the point (have probably passed it in Greece) where repressing local resistance to their colonial agenda diverts more wealth than can realistically be extracted from the colony in question.

            Perhaps Augustus would have sent in the legions for some gunboat diplomacy. But then, the Roman emperors never were known for their grasp of the concept of imperial overstretch.

            – Jake

            • jomiku said, on August 13, 2011 at 2:14 pm

              Legions and gunboats in the same sentence?

              I’d say Germany lacks the imagination to make the Greeks more German in practice. I can’t find a way to say the rest without touching on WWII and I don’t want to go there.

              Part of the brilliance of Augustus was the integration of various peoples into Roman ways. This was done peacefully. Even in Italy, most of the non-Roman population was distinctly non-Roman during the Republic. While Rome of course conquered, they learned to make people Roman, from Spain across N. Africa to the east.

              • JakeS said, on August 13, 2011 at 2:28 pm

                “Making Greece more German” would not solve the problem, because the problem is that the foremost German foreign policy objective since the collapse of Bretton Woods has been to get someone else to eat the unemployment caused by their inflation neurosis. Making Southern Europe more German would simply mean that Germany had to bear the full unemployment cost of its neurotic inflation. At which point the German public would riot like it’s 1848.

                “Do like Germany (i.e. be a net exporter)” is not a valid economic recommendation, for the same reason that “do like Switzerland (be a tax haven),” “do like Singapore (be a city state with a major transshipment port),” “do like Egypt (control the Suez Canal)” or “do like Botswana (find diamonds)” are not.

                – Jake

  3. Barry Thompson said, on August 12, 2011 at 11:56 am

    “So – why can’t the ECB just continue buying? Well it could.”

    And it should. Targetting rates is absolutely the right policy. Italy and Spain will have no problem servicing their debts at low interest rates. Full stop.

    It’s not in northern europe’s interest to hang Italy and Spain out to dry like they have done with Greece, Portugal and Ireland.

    I don’t see how ECB buying bonds is ever unsustainable – the ECB can create money.

    • JakeS said, on August 12, 2011 at 2:06 pm

      I can’t see why the ECB has any business relieving German, French and British banks of the sovereign bonds issued by internal deficit members of a currency union specifically and explicitly designed to turn internal deficit countries’ sovereign bonds into trash.

      What should be done is repeal Art. 123 of the Lisbon Treaty (first introduced in the Maastrict Treaty), to permit the ECB to function as a proper central bank.

      But absent that, the internal deficit countries could start a bank, capitalise it with newly issued sovereign bonds, have that bank buy bonds in the primary market (at whatever interest rate it wants – it does not matter, as it is simply a pass-through accounting fiction) and have the ECB either rediscount the bonds or buy them from the bank (which is permitted by section 2 of Art. 123, since apparently passing through the bid-ask spread of a private bank turns a Eurozone bond from a debt certificate into a monetary instrument).

      – Jake


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