Last September, you may recall, the European Central Bank (ECB) announced their new bond-purchase plan, Outright Monetary Transactions, or OMT. What’s interesting is that the OMT hasn’t purchased a single bond, and yet Spanish and Italian bond yields have fallen a few hundred basis points since then, making the debt burdens in those countries a bit more sustainable. So besides the power of its name, how did the OMT turn things around?
Put simply, the OMT’s most significant action was to change the risk characteristics of sovereign debt in Europe. By offering to purchase peripheral (Spain, Italy, etc.) government debt and put it on its own balance sheet, the ECB is implicitly spreading the risk across all Euro area countries. As a result of this lower risk profile, existing investors have been more willing to hold peripheral debt. Ultimately, the ECB’s explicit admission that it is the euro area’s “lender of last resort” has significantly diminished break-up risk and sovereign default risk.
So, is the crisis over? Well, not really – the most acute phase is behind us; however, Europe still has some major debt overhangs to resolve if the Eurozone economy is to stay on the path of stability. And how will they do this? Theoretically, there are five options; however, only two of them are realistic and actionable.
1. Inflate that debt away – The Eurozone could inflate its way out of its debt burden. Inflation would reduce the real value of the debt stock, and would increase the GDP portion of the debt-to-GDP ratio. Realistically, though, in the current inflation-targeting world, this simply isn’t a possibility.
2. Just restructure that debt – A member country could restructure their debt; however, European officials made it abundantly clear last year that Greece’s restructuring was a unique case. After all, that episode triggered significant market turmoil with major systematic implications. Certainly, any sniff of a potential debt restructuring would pull investors away from the sovereign in question. So, let’s call this an option not worth considering. (Remember, I said there were “theoretically five options.”)
3. Mutualize that debt – This option comes in two types. The “lite” version is what we’re seeing with the OMT. It goes some way towards sharing sovereign risk across the region. Eurobonds are the other option, though right now, Eurobonds are more like a fiscal unicorn – everyone agrees they’re an interesting idea, but no one’s actually ever seen one. Unfortunately, at best, Eurobonds are several years away; at worst, they’ll remain in the realm of fantasy.
So now we come to the harsh reality of our two “plausible” options.
4. Good ol’ fiscal austerity – Tastes like medicine.
5. Economic growth – Nice, if you can get it.
Sovereigns have been trying options 4 and 5 for the past few years, but to little avail, since markets keep testing governments’ nerves. However, the OMT buys the currency area more breathing room to continue pushing through necessary reforms. Hopefully, it also provides some leeway to make these adjustments in a much less financially stressful environment. Though, what this ensures is that fiscal consolidation and structural reforms will continue to be themes in global investing for several years.
Over the medium-term, we would expect low growth interspersed with bouts of volatility centered on political events. While that may not sound like the most uplifting outlook, if you compare that to the financial-market dystopia of the recent past, it begins to sound pretty darn good.