The problem confronting the eurozone is one of asymmetry and non-linear risks.
So says Nomura in a research note sent to clients on Thursday. Asymmetry between a country like Italy and a country like France, with only the ECB in between.
Hence the question, which Nomura poses: — what flavour of ECB bond-buying we will get?
Before we consider that question, here’s the quick summary of why only the ECB can return Italian debt to sustainability:
1) Financial institutions are scaling back exposure as they boost CARs That’s because regulators are pushing banks to meet 9 per cent tier one capital ratios and this has only furthered the momentum by which banks, and other players in the market, decrease their exposure to Italy. They are jumping out of the pool and have little incentive to get back in.
2) EFSF – not a solution Even if the EFSF insures part of the sovereign’s debt because it’s not that credible, the protection will actually be triggered when investors expect because the EFSF will itself decide when to pay out.
3) The G20/ IMF solution And did we mention that the IMF is just sending monitors in to track Italy’s progress, and emerging markets are so not interested in bailing out Europe? Which only leaves us with…
4) The need for the ECB balance sheet to be deployed Before considering the future of the ECB’s Securities Market Programme (SMP), here’s a nice compare and contrast of the weekly purchases of sovereign debt under the programme to date versus Italy’s refinancing needs (click to expand):
Mind the scaling on the y-axis to get a sense of how much the buying would have to be increased if the Italian bond market were to be substantially supported.
Given that, the Nomura analysts ask: “Will the ECB blink or merely twitch?”
On the twitchy end of the scale, we have…
Option 1: The ECB steps up its bond purchase amounts temporarily; but remain ready to step back (60% probability) The ECB increases its bond purchase amounts over the coming days to provide critical support for the Italian auctions (starting Monday next week). In terms of amounts, it is possible we could see the weekly purchase amounts ticking up to what we saw during the first weeks of August (between EUR15-25bn). …this intervention amount may be sufficient for Italy to maintain market access. In essence, the SMP could be focused on drawing down the inventory of primary dealers heading into bond auctions, thus blurring the line between supporting secondary and primary markets.
The analysts suspect going down this road will mean that a Memorandum of Understanding with the European Commission (plus ECB and IMF) will need to be signed by Italy for the bond purchases to continue. Of course, not knowing who is there to sign such a document for the Italians is also tricky, though Mario Monte being confirmed as the next prime minister could help.
Getting more twitchy…
Option 2: The ECB explicitly pre-commits to buying a nominal amount of bonds over a set period (30% probability) This scenario basically has the ECB announcing that it is now committed to buying a certain euro amount of periphery government bonds in the next, say, six months. If this announcement were to be made between now and the ECB’s December governing council meeting,…
As we have said previously, such an unconditional commitment would be tricky for the ECB to defend, especially as it would give rise to moral hazard and would lessen the market pressure on Italy and Spain to implement necessary reforms. The German opposition to such an ECB move would be significant. But it is possible that the current financial market fragility has unsettled the ECB sufficiently to disregard its “conditional rescue” requirement.
Option 3: The ECB commits to a significant balance sheet expansion through a proper QE operation (10% probability) This would involve the ECB first lowering its policy rate from 1.25% to 1%; the de facto lower bound of the policy rate for the ECB. In addition, this scenario has the ECB announcing that it would engage in significant bond buying over an extended period of time. The main difference from the SMP bond buying is that these purchases would be formally unsterilized. It is worth noting that a second possible difference with the SMP could be if the ECB sought to avoid discriminating in favour of one country via a QE program by spreading its purchases of government bonds across all of the 17 euro area governments with the relative weights possibly determined by the relative GDP sizes. In other words, a proper QE ECB type operation would not just involve the ECB buying Italian and Spanish bonds. It would also involve significant purchases of German and French government bonds.
The Nomura analysts don’t think this is likely… yet. Hence the 10 per cent probability assigned to the option. They think the situation would have to deteriorate significantly beyond what has already been seen. Also, given how abhorrent it will be for Germany to unleash such inflationary pressure, one does wonder whether this is a 10 per cent chance of QE or a 10 per cent chance that the eurozone breaks up.
After this week though, with Italy’s bond market misery and Greece only just getting around to forming a government after giving the markets a referendum-induced heart attack, 10 per cent for that scenario seems a bit on the low side.
What happens next? The scenarios for Italy – FT
Only the ECB can save Italy now, but it can’t act alone – FT
The relevant articles of the Lisbon Treaty for the sovereign debt crisis – Credit Writedowns
ECB’s Policy Makers Say They Can’t Do Much More to Stem Financial Crisis – Bloomberg