Verdict looms on legality of ECB bond purchase programme
Remember the German Constitutional Court’s (GCC) hearings last June on the European Central Bank’s (ECB) outright monetary transactions programme (OMT)? The GCC is expected to announce its ruling towards the end of October — perhaps already this week.
Why is the OMT so important?
In the summer of 2012 the euro crisis was at its worst — Italy and Spain were too-big-to-fail, but they were also too-big-to-bail. Both countries, especially Spain, were in serious trouble and “redenomination risk" was a phrase heard often. Spain’s exit from the monetary union would have led to a partial default of its sovereign bonds, currency devaluation and a loss of purchasing power of deposits.
German court's crunch decision on ECB bond-buying is due shortly. Photo: BVerfG
No wonder that sovereign bond yields were trading at euro-era highs and the financial system was hit by a slow-moving bank run, a bank jog, moving billions of euros from their banking systems to other countries that were deemed to be safe.
At the darkest hour the ECB’s president, Mario Draghi, made a speech promising to do “whatever it takes”, and soon afterwards the ECB announced the new OMT programme which would effectively backstop the sovereign debt of the countries that had applied to and fulfilled the conditions of the programme.
The charts below clearly show how the bond yields of Spain and Italy started to come lower after the announcement, and due to the lower German yields, the move in yield spreads was even more dramatic. At the same time, the Target balances of the two countries started decreasing, which is another sign of easing market pressure.
Source: Saxo Bank
Source: Saxo Bank
Source: Saxo Bank
Why is this a problem for Germany?
The German constitution states that the final word on the government’s spending comes from the German parliament. As the OMT programme is all about the ECB purchasing the bonds of the programme country, the ECB would take on interest rate risk and credit risk.
The OMT is conditional — meaning that if a country would suddenly stop adhering to the predefined conditions, the ECB would be forced to stop its purchases, and possibly even begin selling its existing holdings. This would mean the ECB would be “buying high and selling low”. As the largest shareholder of the ECB, the German central bank, and in the end the German tax payer, would be forced to cover the difference. The credit risk would come from a possible haircut of the bond’s value in a restructuring or an outright default, and the loss would have to be dealt in a similar manner.
What choices the constitutional court has?
The court held hearings last June, and testimonies and arguments were presented among others by the ECB and the German central bank. A decision is expected now at the end of October, but no exact date has yet been given. The most probable scenario is the second of the two outlined below while the first is highly unlikely.
1. The GCC decides that OMT is against the constitution: Germany cannot overrule the ECB, so unless the ECB deletes the tool from its arsenal, Germany would be forced to leave the monetary union. Note that even if the GCC only attaches strict conditions to the OMT. Stocks, bonds and the euro would plummet. This would leave us with two additional paths:
a) The ECB drops OMT — crisis would erupt immediately and the euro would be on brink of breakup. The ECB would have to be quick to come up with new measures, and the probable choice would be large-scale, ultra-longer term LTRO refinancing programme — already dubbed by the markets as VLTRO. By extending the maturity and possibly using a fixed loan rate, the central bank would at the same time be able to provide very dovish forward guidance. But the previous LTRO did not work for long, and the current asset quality reviews and stress tests are supposed to penalise banks that use the LTRO, although the European Banking Authority was quick to dismiss such rumours.
b) The ECB keeps OMT — Germany would have to leave the monetary union. Without the backing of Germany, the monetary union would lack a sufficiently large and credible member and confidence in the union would be destroyed immediately.
2. The GCC decides that OMT is legal: The court might also require some minimal adjustments or conditions like periodical reviews by the German parliament or capped purchase amounts. While this is the most probable solution and should add some new power to the current bull market, these checks and balances could also become a source of continuing uncertainty. A lot depends on the conditions.
3. The GCC refers the case to the European Court of Justice (ECJ). The ECJ would have to decide if the OMT is legal under the European law. While this would create some short-term confusion and uncertainty, in reality the ECJ would certainly rule in favor of the OMT, and after such a decision the GCC would surely find the OMT constitutional under German law as well. This could create an interesting opportunity to “buy the dip” as the news of the delay are digested by the investors.
More on the topic:
July 12 How to limit the ECB’s OMT?
—Edited by Clare MacCarthy