August 6, 2012

Following Mario Draghi’s press conference last Thursday, markets experienced a sharp, but predictable disappointment (which, incidentally, was largely reversed on Friday). Earlier last week, markets obviously got carried away over-interpreting various statements made by Mr. Draghi and EMU policymakers as being hints of imminent coordinated action. Last Thursday, Mr. Draghi said the ECB would not accept the ESM as a counterparty, cooling debate over an ESM banking licence. Furthermore, he announced the ECB is revamping the SMP to target shorter maturities, be fully transparent and possibly not fully sterilised, but requiring sufficient government reform efforts and EFSF/ESM activation as a necessary but insufficient pre-condition.

While the programme’s exact design is still a work in progress, some of Mr. Draghi’s hints, such as the ECB addressing the seniority issue – one curb on the old SMP’s effectiveness – or sterilisation being up for debate, should encourage the markets. Mr.Draghi justified SMP 2.0 via two observations: market fragmentation, particularly in interbank markets, and the fact that peripheral bond risk premia seem to increasingly include conversion risk, which unlike counterparty risk falls under the ECB’s remit, i.e. supporting the euro. The second and more recent argument seems more valid than the first, since market fragmentation is partly due to counterparty risk and is, in fact, exacerbated by the ECB’s super-generous liquidity provision. However, even if the ECB joins forces with the EFSF/ESM in buying government bonds its mandate, with price stability as the primary objective, will ultimately put a lid on the size of its interventions. While it is obviously impossible to determine an amount which if exceeded would clearly threaten price stability, the statement “whatever it takes” should still be taken with a pinch of salt. Another thing to note for the medium term: by announcing it will focus any possible bond purchases on shorter maturities the ECB sets a risky incentive for governments to reduce the average tenor of their debt, exposing sovereigns to greater rollover and interest risk.