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Limitations on the ECB bond purchase policy [ClearOnMoney]
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Limitations on the ECB bond purchase policy

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Commentary

Limitations on the ECB bond purchase policy

11 Sep 2012 by Jim Fickett.

Markets are doing very well following last week's news that the ECB has supposedly promised unlimited bond purchases for countries in trouble. “Unlimited”, though, only means no pre-set cap, and the buying comes with big limitations. The biggest is explained well by both John Hussman and the Financial Times, and is this:

The ECB has promised that sovereign bonds will be purchased only in the context of a full bailout with strong conditions attached. Now what happens when the country being helped (inevitably) falls behind on its (always overly optimistic) promises? The dilemma will be between stopping the purchases, and risking the euro, or continuing the purchases, and losing credibility (and German cooperation). From the FT:

Renewed bond buying will be unlimited, unlike last time. Help will be tied to reform and austerity conditions imposed from Brussels, with the International Monetary Fund asked to supervise errant countries too. Most importantly, the ECB says it will consider itself ranked equally with other creditors, so its buying will not weaken the credit quality of privately held bonds. …

The icing on what already looked like a very tasty cake was the ECB’s surprise decision to loosen its collateral requirements again, meaning it will accept junk-rated assets as security against loans and even some assets denominated in foreign currencies.

Put simply, the central bank is ready to absorb a big chunk of Europe’s credit and currency risk, making the remaining assets safer. …

Governments everywhere have a tendency to be over-optimistic in their forecasts, and those in the eurozone even more so. If and when Spain or another country being helped by the ECB misses its Brussels/IMF targets, the ECB will face a hard choice.

It could threaten to stop buying bonds in order to enforce further austerity to put the country back on the fiscal track, at the cost of a deeper recession. But that would risk domestic turmoil and the rise of populist, anti-reform parties, as in Greece, while the market would be sure to go into a deep funk.

Or the ECB could accept that a country had tried its best, and keep buying bonds even though targets were missed. But that would risk a backlash from Germany and a crisis of confidence in the central bank.