6 Sep 2012

Draghi’s backdoor bailout of Spain

Make no mistake, the flurry of acronyms unleashed by European Central Bank President Mario Draghi today is a backdoor bailout of Spain. Or rather, it could be a backdoor bailout of Spain if the Spanish Government signs up to newly attached strings and the indignity of oversight from IMF-ECB-EU Troika.

The markets broadly went in the right direction in response to the announcements of “Draghi Day”. Spanish and Italian bond yields fell, world stock markets rallied.

First there will be unlimited purchases of government bonds (known as “Outright Monetary Transactions” or OMTs), in Spain and probably Italy, but only if they sign up to Troika inspections and more austerity and economic reform. Think hundreds of billions of euros, if necessary. To be clear, Spain would not be required to request a full Greek-style bailout, but instead a mini precautionary bailout. To harness a currently popular theme, this backdoor bailout offered to Spain is something of a “shade of grey” between no bailout and the full Greek.

Instead of formally having to raise taxpayer cash or guarantees with the requirement for political ratifications, the money is coming from Mario’s Magic Money pot, which similar to the Bank of England’s QE. Instead of actually using the money to fund government spending commitments (as in Greece), the money will be used to buy bonds and keep government borrowing costs down and sustainable.

Mr Draghi has assessed the eurozone and seen that its monetary system is broken, “fragmented” in his words. What today’s announcement represents is a challenge to the financial markets (which are currently betting on a Spanish euro exit) to make high yield profits out of funding Spanish banks and government debts at lower, more sustainable interest rates. Outright Monetary transactions will be a “fully effective backstop that removes tail risks from the euro area”, underlining that “the euro is irreversible”.

In his own words: “OMTs will enable us to address severe distortions in government bond markets which originate from, in particular, unfounded fears on the part of investors of the reversibility of the euro.”

He also – in a glorious 83-word sentence – greatly increased the toxicity levels for loans that eurozone banks can swap/park at the European Central Bank in return for cheap funding. They’ll be taking old Peugeot 405s soon. They can even park sterling dollar and yen loans in Frankfurt’s toxic debt vat. This will help funding for troubled banks.

Four questions crop up straight away:

1. Will Spain comply? The pressure will be enormous. Having accepted a limited bailout for its banks, it would be a humiliation for PM Rajoy. But if he can dress it up as something other than the backdoor bailout that it is, perhaps it is possible. Draghi continually stressed how important this conditionality is. Perhaps this is a reference to the original bond-buying programme, which some in Frankfurt saw as inadvertently underpinning Silvio Berlusconi’s eccentricities as Italian leader. In contrast the OMT has strings.

2. Will Germany rebel? Mario Draghi made a point of saying that the decision approving this was “near-unanimous” apart from one central bank: “there was one dissenting view, it is up to you to guess,” he said. And that was Germany’s Bundesbank. Outvoted, not just by a southern cabal and the Mediterreanean island nations, but by fellow northerners, despite being the principle funder of the ECB. Hardly the German imperium that the eurozone is occasionally referred to. But how’s that for democracy?

What is really interesting though is that Bundesbank President Weidmann has not resigned, as his two predecessors did in recent months. The German press says that Chancellor Merkel intervened to stop Weidmann resigning.

So despite the vote against it was not a veto, and the absence of a resignation to me is a tangible sign of a softer German position. This is consistent with the call I have been making about Germany paying up eventually. But there could be a risk of a backlash. How can Malta and Cyprus outvote Germany?

3. Will the ECB really stop purchasing bonds if a recipient nation backslides on the fiscal plan? Even if it faces huge losses from a default as a holder of those bonds? Are its fiscal conditions therefore without clout?

4. Is Greece being treated differently? Yes, on collateral, on bond purchases, all over the shop there are ominous signs that Greece is being treated more harshly than Spain. It will be a rather tense time as the Troika inspectors finalise their report into Greek non-compliance with its bailout programme in the coming weeks.

For these reasons this seems to me like a bridge to get the eurozone over the next year, and through the tumult of the only elections that matter: the ones in Germany in a year’s time. All in all, in that regard, I think this will work, if Spain plays ball.

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