Draghi Plan Revealed: Will Unlimited Bond Buying Work?

ECB President Mario Draghi
ECB President Mario Draghi

ECB President Mario Draghi announced yesterday an unlimited ECB Bond buying program to help stabilize the Euro and reduce short term sovereign borrowing costs for indebted periphery countries such as Spain and Italy.

However, the ECB’s latest decision comes with some future risks that the ECB could potentially lose money on the bonds if fiscal policies in those sovereign countries prove to be ineffective and they fail to achieve imposed conditionality targets.

After presenting “Outright Monetary Transactions” (OMT), Draghi defended the bond buying program from Bundesbank President Jens Weidmann, the lone dissenter, who later questioned whether OMT fell within the ECB’s mandate and claimed “Its tantamount to financing governments by printing bank notes.”

Draghi did not single out Weidmann by name but he alluded to his history of dissension before reporters.

Draghi responded to those dissenting concerns by stating, “We act independently in determining monetary policy.”

“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.”

Draghi explained, “Under appropriate conditions, we will have a fully effective backstop to avoid destructive scenarios with potentially severe challenges for price stability in the euro area.”

“The ECB won’t have seniority over other bondholders when it comes to purchases under the OMT”, Draghi pointed out after questions were raised by investors about whether the ECB would have an advantage in the future event of debt restructure .

The implementation of OMT is still contingent on the approval of the ESM rescue fund by the German Constitutional Court, which will be determined on September 12. 

The central bank will strictly enforce the conditionality clause which relates to issues such as austerity-deficit targets and will be focused on the ability of the country to repay its debt.

The adoption of OMT will likely first target the periphery countries of Spain and Italy, which struggled with high borrowing costs over the past few months, but it will be available to all euro area nations.

 “As we said a month ago, we need to be in the position to safeguard the monetary policy transmission mechanism in all countries of the euro area” Draghi said.

Nouriel Roubini, an economist at Roubini Global Economics spoke this morning to Bloomberg’s Guy Johnson and said “conditionality is the biggest concern” even while acknowledging that the ECB is quite strict with conditionality.

Roubini pointed out that within the ECB there are many people nervous about the size of the OMT program.

Here is the Bloomberg Video of the interview.

Graeme Leach, Chief Economist at the IOD,  shared his view about the OMT program with the Guardian, “The ECB’s decision to enter secondary bond markets could be the game changer the IOD has long argued for. But there’s a hitch. ECB action is conditional and depends on countries such as Spain signing up for even more austerity. The key question is whether more austerity is politically possible with 25% headline and 50% youth unemployment.”

Text of Draghi’s speech.

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