European Central Bank (ECB) president Mario Draghi’s promise to do “whatever it takes to preserve the euro” and create a new bond-purchase program has been positive for market sentiment. But the program also carries real dangers if it breaks the fragile consensus on the board of the ECB and eases the pressure on governments to create a “genuine” economic and monetary union.
Known as Outright Monetary Transactions (OMTs), the new bond-purchase program looks primarily like a liquidity backstop—the ECB is effectively guaranteeing that no “solvent” euro-area country will fail as a result of unfounded fears about the future of the euro. But, if the OMT program were to guarantee permanently low interest rates for compliant euro-area countries, it would also begin to influence their solvency. To illustrate this, we made some projections for Spanish government debt assuming different interest rates.
In the baseline scenario, we assume that the economy remains in recession until 2014 but that nominal GDP growth then rises to 3.25% per annum and that the budget balance net of interest payments moves into a small surplus. If we assume that the average refinancing rate on new borrowing is 5.0%, Spain’s debt-to-GDP ratio peaks at 106% in 2016 before starting to decline. However, progress is slow and the ratio remains above 100% until the end of the simulation.
If we assume a 6.5% refinancing rate, our projections show the debt-to-GDP ratio moving onto an explosive path—similar to the outlook before the ECB’s intervention. But if we assume a 3.5% rate, the debt-to-GDP ratio starts to fall quite rapidly after peaking in 2016. Crucially, the same thing happens if we assume an even deeper recession and a much slower pace of fiscal adjustment—though the debt-to-GDP ratio does peak at a higher level.
These scenarios show how important the interest-rate assumption is when projecting future debt ratios and also highlight the potential benefits of Eurobonds—joint and several borrowing backed by all euro-area countries which could be used to help lower borrowing costs for the periphery. Of course, Eurobonds are off the table for now but aggressive OMT purchases could, in theory, achieve much the same result—by the back door.
This is one of the reasons why we think the ECB needs to tread a very narrow line with the OMT program. So far, the strength of the ECB’s message has helped shift the euro area away from a self-fulfilling “bad equilibrium”. As a result, countries like Spain and Italy now have a fighting chance of completing their daunting fiscal adjustments.
But aggressive use of OMTs to lower bond yields would take the ECB into dangerous territory and could bring it into conflict with the ban on monetary financing in the Maastricht Treaty. Under these circumstances it might be difficult to sustain the broad, but fragile, consensus in favor of bond purchases on the ECB’s Governing Council (which already excludes Bundesbank president Jens Weidmann).
The other danger is that it would set the wrong incentives for governments. If the ECB removes too much pressure from governments, history suggests that they might not take the critical steps needed to forge a genuine economic and monetary union. While this would not necessarily prevent the euro area from stumbling through the current crisis, it would leave many of its problems unresolved.
The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AllianceBernstein portfolio-management teams.
Darren Williams is Senior European Economist at AllianceBernstein.