Tuesday, 9 October 2012

An OMT swap versus a QE injection - how should central banks buy bonds?

The ECB is planning to undertake a form of bond yield stabilisation for peripheral countries with a new tool, Outright Monetary Transactions, to deal with the on-going Sovereign Debt Crisis in the Euro Area.  Many people are treating this as another example of non-conventional monetary policies that will use central bank money to affect asset prices and at first glance it seems so as well.  But after some reflection, OMTs seem me to be a little more, and I hesitate to use the word, insidious and takes us right back to classic debates about whether monetary policy should prick bubbles and/or identify them.  The answer used to be no.  What mattered was the shock or structure that might have led to any mispricing and to try and deal with that by market reform or some examination of the implications of the shock for macroeconomic stability: central banks, so the argument ran, do not generally think they have more information than the market and so ought to concentrate on the cause of mispricing rather than attempt a direct correction - cause rather than symptom was the proper concern.

Under OMTs, in principle, there will be unlimited purchases of (one to three year maturity) distressed sovereign debt, providing the country whose debt is being purchased is on track under its IMF programme.  The purchases will be sterilised, presumably by sales of more stable sovereign debt, and so simply represent a re-shuffling of the bonds held by the private sector from distressed to more stable.  In effect the ECB is buying risky debt, financing it by selling less-risky debt and putting on a convergence trade so that it will make money if the risky debt goes up in price relative to the stable country’s debt.  In effect the ECB is doubling up, if its overall policy strategy works, it will lead both to a convergence in spreads and also a healthy rate of return, with perhaps a bonus for staff (!).

But rather like selling foreign exchange reserves to buy domestic currency, this kind of sterilised intervention is a kind of strategic game with the financial markets who though may collectively have deeper pockets than the central bank may not wish to challenge central bank policy institution-by-institution.   The idea is that the excessive risk spread does not represent a fair reflection of the credit risk of an individual sovereign but somehow results from contagion or bubble-like forces.  This opens up a number of issues: (i) should the ECB behave like a hedge fund, or specifically as the counterpart to the break-up trade put on by a typical highly leveraged financial institution?; (ii) how do we estimate robustly the fundamental and non-fundamental component of any asset price and esnure that our purchases bring the price to fundamental value?; (iii) how do we contain any moral hazard issues arising, whereby debt issuers may feel they can “misbehave” in the presence of ECB insurance?; (iv) to what extent are ECB purchases of sovereign debt an attempt to offset structural weaknesses in its own policy design – given the financial markets pricing of exit or redomination reflects ECB policy - and so can further ECB policy be used to assuage risks in its own policy? (v) can open market operations of this sort, deal with the structural payments problems and debt overhang faced by Euro Area countries?  My answers to all of the above makes me rather worried about the ultimate efficacy of OMTs.

So you may ask why is QE any better?  I am not completely sure.  But QE is about swapping interest bearing reserves for government bonds held by the non-bank financial sector.  And this swap is specifically designed to replicate the impact of a notional cut in Bank rate, so that 10 year government yields fall to the point that they would have done if we could have had negative Bank rate or equivalently a longer duration of Bank rate at the zero lower bound (ZLB).  The swap is designed to be reversed so that any reserves issued will go out of circulation – with no permanent impact on the price level.  So QE adds us to a temporary injection of reserves that leaves the private sector long (liquid) reserves and short (less liquid) bonds for an uncertain but extended time.   Given the hedge fund analogy, the Bank of England and HMT in this case is actually betting against itself because when (or if) the economy stabilises it will take a large loss on the bonds it has bought.  In some sense, because “it is betting on the opposition" and so providing a commitment technology of the sort that says believe us when we say that we will keep interest rates low for as long as is required because when they are raised it will cost us a heck of a lot of money.

OMTs, on the other hand, are not designed as an instrument to compensate for the ZLB but result from some view that the market-determined rate for distressed sovereign spreads incorporates something other than credit risk, that is not well pinned down by fundamental factors such as the current and prospective stance of fiscal policy alone. Remember if they were on track during an IMF programme, the spreads ought to come back in. And so that is why, OMT sounds more like the defence of an exchange rate peg rather than a QE-type policy.  The advantage here, compared to an exchange rate peg, is that this interest rate peg is being defended by domestic central bank money.  But because  operations are to be sterilised, there is no overall change in the relative quantities of bonds and money simply the risk composition of debt held by the private sector.  The literature on sterilised interventions in forex markets does not suggest any great hopes for OMTs.  I therefore wonder whether OMTs should be unsterilised so that at least the exchange rate can jump downwards.  

Overall there clearly is a missing instrument (or two or seventeen) in the Euro Area, which might be a form of country specific non-conventional policy, it is just that I am not sure that OMTs as they currently stand are the answer.  What we probably need is more debt issued by stable sovereign states, i.e. Germany, which might give the central bank more ammunition.  It is this debt that could then be bought by a QE-style operation that would increase central bank money and might well help lead to a large depreciation in the Euro.  And then for some kind of swap between risky and less risky debt in specific lots. I will return to this question.  Meanwhile OMT looks at least one or two letters short of being the required instrument.

1 comment:

Ed Paine said...

I feel that when looking at OMT's your point about the danger of moral hazard is particularly valid. As a holder of overly risky dept I would be tempted to exchange my dept for less risky assets and then to repeat the process.

There is not stick offensive with this policy plan. Only Carrot.