Further thoughts on the fiscal implications of OMT

Florian and I are having a good discussion on the fiscal implications of the ECB’s OMT program. I don’t have much time right now, but I want to make two points in response to his latest post. 

First, Flo’s latest post taught me something I didn’t know: The ECB’s use of the term “sterilization” is somewhat different from the textbook use. A sterilized intervention is usually defined as an action by the central bank that leaves the monetary base unaffected. What the ECB did in its SMP program (and, as best we can guess, that’s what it will do in the OMT program) was buying government bonds with newly created base-money and simultaneously taking short-term deposits from commercial banks in the same amount. So, figuratively speaking, the ECB prints a new euro, uses it to buy government bonds from the banks, and offers the banks the opportunity to deposit the newly created euro with the ECB at interest. Clearly, this intervention increases the monetary base, although the money in circulation stays unaffected.

Fair enough. So what does this mean for our discussion on the fiscal implications of the OMT program? Nothing.

What matters for our discussion is the effect of the OMTs on the ECB’s net profit: roughly speaking interest earnings on assets minus interest payments on deposits. Under conventional sterilization the ECB would reduce its holdings of interest bearing assets and hence reduce its interest earnings. Under the ECB’s sterilization technique, new liabilities are incurred which increases the ECB’s interest payments. As long as the ECB’s lending interest rate is not substantially different from the deposit interest rate (both are essentially zero at the moment), the effect of net profit is the same in both cases.

So the particular way how OMT bond purchases are going to be neutralized seems to me quite irrelevant to our discussion.

The relevant question is this: Will the bonds the ECB is likely to purchase under the OMT program be bought for more or less than they are really worth. If the price the ECB pays is too high there will losses to the ECB and therefore, eventually, to all Eurozone governments except those whose bonds were being bought. If the price is too low there will be gains to the EZ governments. It is, of course, possible that the ECB knows exactly the true default probability of periphery governments and therefore the true value of their bonds.

However, I think the most important thing to notice is this: the purpose of the OMT is to signal to the market the ability and willingness to lend without limit to EZ governments. If the public believes that promise, the ECB will never have to make any actual bond purchases at all. The only circumstance in which the ECB would have to buy periphery bonds is when investors are so convinced that those bonds are going to default that no promise of Mr Draghi can calm them. In such a situation I find it highly likely that the ECB will incur losses on its bond purchases.

Advertisements

11 thoughts on “Further thoughts on the fiscal implications of OMT

  1. I read through your very interesting discussion here (I admit I did not read everything ;)). I just want to give a remark on your last paragraph and to the risk of reaching a point at which “investors are so convinced that those bonds are going to default that no promise of Mr Draghi can calm them”. As you mentioned previously, the OMT program is Draghi´s answer to prevent a self-fulfilling debt crisis. If this “answer” is efficient then the risk of reaching such a point is close to zero and the ECB will never effectively need to buy the bonds.
    Refering to the Corsetti/Dedola paper, (http://www.bancaditalia.it/studiricerche/convegni/atti/Conferenza_Ando/CORSETTI-paper-calvo-code-rome.pdf) a country which can rely on the printing press is likely to experience such a crisis only if markets expect the costs of inflation which follow from printing money to be higher than the costs of default (due to resulting refinancing problems in future etc.). In contrast, a country which cannot rely on the printing press has to raise the money from taxes to serve its debts. This represents a significantly higher risk of default and therefore of suffering from a self-fulfilling debt crisis as raising taxes to a large extent will likely be very painful for a society (thus representing high “costs” of servicing debts).
    If the OMT program works properly, the risk of default and therefore the risk premiums should be close to zero as the the respective countries can always roll over their existing debts by refinancing them from the ECB. In my opinion, there is a serious flaw in this thought. As pointed out by Corsetti/Dedola, the problem of experiencing a self-fulfilling debt crisis does not only result from a country´s expected “ability to pay”, but primarily from its expected “willingness to pay”. If the costs of servicing the debts are expected to be too high given the respective debt level, then such a crisis can occur. The problem with the OMT program is that it is based on a kind of “conditionality”. A country has to accept a strict austerity program to get unlimited access to ECB financing. The resulting “costs” of servicing its debts can therefore be closely as high as if it has to refinance its debt from raising taxes. The possibility of experiencing a self-fulfilling debt crisis and the necessity that the ECB effectively needs to buy the bonds of troubled countries seems therefore very relevant to me.

    • Boy, that Reading Club is really paying off!
      I’m not entirely sure what your point is. But let me expand on my last paragraph, because I think it reinforces your comment. In typical self-fulfilling crisis models (like this one here: http://www.minneapolisfed.org/research/sr/sr211.pdf) you get multiple equilibria only if your “fundamentals” (your debt-GDP ratio, say) are in a certain range, in which a default is neither certain nor entirely unlikely. Cole and Kehoe refer to this range as the “crisis zone”. In that zone you can get a self-fulfilling debt crisis; in the simplest case you have two equilibria: (1) investors expect no default, the interest rate is low, there is no default; (2) investors expect default, the interest rate is high, the government defaults. OMT is supposed to coordinate investor expectations on (1) and to avoid (2). The only thing the ECB has to do is to promise, credibly, that they would lend to the government (buy their bonds) without limit in case private investors won’t. If the promise is credible, the ECB would never actually have to follow through on the promise. They would never have to buy any bonds at all. The only scenario in which the ECB would have to buy bonds, arises when private investors expect a default no matter what. Then the ECB would become the sole lender to the government and bear all the risk of a default.

  2. I’m on the train to Vienna and heading to Madrid tomorrow, so not much time to go too in depth here, but let me give it a try. Regarding how the prices of bonds might develop and what this means for the ECB losses (or gains), I did a comment on that in our old discussion. What your net profit argument is concerned, I’m not sure I agree with you when you say that no matter how the ECB sterilizes, the result is the same. Let’s assume a hypothetical case that looks as follows:

    The ECB (in order to conduct “conventional sterilization”) starts with €100 worth of German bonds that pay 2% each. No other assets on its balance sheet. Under conventional sterilization, it would now buy €50 of Spanish bonds, which let’s assume pay 4% interest, and in turn sell €50 worth of German bonds. It used to earn 2% interest on its balance sheet, now (assuming Spain does not default) it earns 3% – in absolute terms €3.

    Under the ECBs actual sterilization policy the ECB would keep its €100 in german bonds (or, if you want, €0 of them, since it doesn’t really matter) yet buys €50 worth of Spanish bonds to add to its balance sheet, and makes up for this by incurring liabilities in the terms of new deposits, which, however, pay 0% interest rate and therefore do not cost the ECB anything. So the ECB now earns an absolute amount of €4 on its balance sheet – more, than in the other scenario. If Spain goes bankrupt in scenario 1 its absolute profit goes down to €1, in scenario 2 it goes down to €2. Assuming in scenario 2 the ECBs balance sheet started out as empty (which is more relistic in this case), the ECBs profits starts at 0 and ends up again at 0 once spanish bonds are written off.

    You can quibble with how the example is set up, but I just don’t see how under any realistic scenario the net profit of the ECB does not depends on the way sterilization is conducted.

    • I didn’t say that the way sterilization is conducted never, and under no circumstances, has an impact on net profit. I specifically stated the condition under which sterilization is irrelevant, namely when the ECB’s lending interest rate (which it is earning on its assets) is the same as the deposit interest rate (which it is paying on its liabilities). Both are at the moment close to zero, so the condition seems to be met. Remember when comparing interest rates not to compare apples with oranges. In particular, you want to look at the maturity structure of assets and liabilities. That’s where I think your example is somewhat misleading, because you compare the yield on long-term government bonds (maturity of several years) with the interest rate on weekly deposits. Of course, at the moment, the deposit interest rate is zero. But it doesn’t have to stay there over the next few years. So a realistic scenario should take the possibility of rising interest rates in the future into consideration.

      I have another quibble with your example: a default normally means principal reduction as well as interest reduction. So it’s not just that Spain would stop coupon payments to the ECB. The ECB would also have to write off, at least partly, the value of their Spanish assets. Those write-offs would, of course, also affect the ECB’s net profit. So what your example envisages as the worst case is actually a not-too-bad case in which Spain only stops interest payments but repays the principal in full.

  3. Hmm…as far as I see it, the ECBs “lending” interest rate in this case is determined by the type of assets it buys, and in the case of any government bond it is significantly not equal 0% i.e. its deposit interest rate. You are formally correct in pointing out that maturities do matter for determining the precise comparison to be made, but it doesn’t change the basic argument – particularly not the argument for any practical application of OMTs, which would buy short-maturity bonds (the ones governments might have problems rolling over), and would likely also only do so when its other monetary policy options are limited or exhausted, i.e. situations where it is unlikely in the near future that it would want to increase its interest rate on deposits.

    As for the effects a write off would have on interest and principal, you are also correct in principle, but my understanding gets murky there. Since buying the bonds does not come at a cost for the ECB, writing them off does not either – as long as the ECB remains in a monopoly position to create new money and inflation is not a problem, it can buy and forget about as much assets as it wants. Any changes in the value of the ECBs balance sheet, which as you are correct in pointing out arise from changes in the interest rate these assets pay (and whether they are still worth anything) should, however, be part of the ECBs net profit. But since the ECB does not need eurozone governments to put up the “capital” it uses to buy bonds, I don’t see why it would need them to “reinburse” them for any losses it incurs on this capital – in fact, that is at the core of the argument here and the one presented by de Grauwe. So again it would seem as if, were the bonds to gain in value, the ECB could distribute this as part of an increase in net profit, but if the bonds fall in value, it just pretends as if they never existed (from a fiscal, net-profit perspective). It’s a “you win or no one looses” situation.

    • And I continue to think that De Grauwe is just wrong here. The ECB is best thought of an €7,575,155,922.19 investment of Eurozone taxpayers. If the ECB’s capital is gone, that investment is gone. If the ECB buys a bond for €100 and gets repaid only 50, that’s a €50 loss. Sure, the ECB has a special source of income which no other institution has, seignorage. But there are limits to seignorage, just like there are limits to any other forms of taxation.

  4. @max “All hail to the reading club”!! – i really like it
    In your words: “investors expect default, the interest rate is high, the government defaults”. My point refers to the question: “When do investors expect a default if a country is or can be supported by the OMT program?”. In your argumentation this does not happen at all if the ECB credibly promises to buy the bonds of countries in trouble.
    Correct me if I´m wrong, but to my knowledge a country can only be supported through the OMT program if it joins the ESM and accepts some sort of austerity program. This is what my point refers to. Investors might not only expect a default if the ECB promise is not credible, but also if they doubt a country´s willingness to (further) accept the austerity program. With austerity probably causing severe social unrest (or expected to cause social unrest) investors might believe at some point in time that the country will prefer to exit the ESM (therefore preventing the ECB from buying its bonds) and default on its debt rather than to risk e.g. civil war. Within such a scenario, risk premiums will rise no matter if the ECB´s promise is credible or not.

    • You’re not wrong, and I think it’s problematic. The more you learn about this whole OMT thing the more you wonder how it’s supposed to work. The fact is that since its announcement, interest spreads have come down very substantially. That doesn’t prove causality, of course. But it seems to suggest that OMT was effective, so far, in signaling the ECB’s willingness to be a lender of last resort to troubled governments.

  5. I fully agree with you that it was effective so far, I just think that this whole system is more fragile than many might think. I also wonder where the variation in interest rates across different periphery countries stems from. If the credibility of the ECB´s promise is the only relevant variable then they should be relatively equal which they are effectively not…Think this is really an interesting subject.

    • Interesting point. Even if the risk premia are the same across the entire Eurozone (which, as long as the ECBs policy is promising enough, which it appears to be, should be the case), interest rates still reflect supply and demand for the money (in what I think is a Keynesian perspective). Of course differences would assume that for some reason the bonds of Spain and those of Italy, to name an example, are not perfect substitutes. The “depth” of the bond markets might be one reason, even though interestingly enough the Spanish market seems to come out ahead of the Italian one since Spain actually pays lower interest rates atm…that Portugal, on the other side, has a considerably less liquid bond market seems a reasonable assumption, which might explain its higher interest spread compared to German Bunds.

  6. Well, thx for the explanation. You are perfectly right that interest rate spreads might result from other factors than simply from different risk premiums. Taking the spreads in interest rates does not do a pretty good job to underline my previous point that the risk of default does not only stem from the ECB’s credibility but also from the expected probability of a country to exit the ESM and default. Here is a link which lists the prices of sovereign credit default swaps which shows a considerable variation across different countries although the announcement of the OMT program has reduced them substantially (http://www.cnbc.com/id/38451750).

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s