The head of European Central Bank, Mario Draghi, is likely to announce the unlimited purchase of government bonds to help the struggling euro countries, sources told Bloomberg. Last week, Draghi informed the European Parliament that he would intervene in bond markets to ensure the survival of common currency. Policy makers are working out the plan, and Mario Draghi will announce it on Thursday at a press conference.
Economists have been urging the European Central Bank to purchase bonds from Italy, Spain, and other troubled countries. Their opinion was that the bond purchase will help these countries lower interest rates and give them some time to recover, without the risk of default.
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Brad Plumer of Washington Post said, ““If Spain and Italy have to pay too much to borrow money (say, because investors are losing confidence in the future of the euro), then those countries risk hitting an unsustainable cycle of doom. Their debts go up, which raises their borrowing costs further, which means their debts go up further… repeat until apocalypse.”
ECB bond purchase will prevent the apocalypse from happening. However, Germany’s Bundesbank continues to raise objections over the plan. Bundesbank President Jens Weidmann has been the least interested to lend a helping hand to save Italy and Spain.
However, there are three critical issues to consider before the Eurozone begins celebrations. One, though the European Central Bank will buy up unlimited bonds, it’s not going to set a “yield cap.” That means, Draghi wouldn’t commit to keep the Italian and Spanish interest rates below a certain level.
Another concern is that, according to Bloomberg, the bond purchases are “sterilized”. That is, ECB would not print euro to buy the bonds. Instead, it will be selling other assets, such as bonds, to pay for the unlimited debt purchasing. Though it eases the fear that helping the troubled countries will lead to explosion in the currency supply, its stimulative effects will be much weaker than the usual bond purchases.
The third and biggest obstacle is that the European Central Bank will not buy debts from any country that doesn’t stick to the new budget rules of the EU. The rule restricts the budget deficit to 3 percent of GDP and structural deficits to a maximum 1 percent. If the countries don’t abide by the standards after ECB has bought their bonds, Draghi said he will sell it.
As of now, the most troubled country, Spain, is highly unlikely to meet the standards. Analysts expect its deficit to be 6.3 percent of GDP this year. Italy has the chances to fall within the limit, but that will hurt its growth and push the future deficits higher.
Bloomberg expects ECB to purchase short-term debts, i.e, bonds that will mature within just three years, to have some breathing space until the long-term measures are taken. The Euro rose half a cent on the news to $1.2596.
“I think the market saw the word ‘unlimited’ and jumped before realizing that the ECB would not expand its balance sheet, as it would sterilise all its purchases and thus this was not the kind of aggressive monetary expansion that FX traders were looking for,” said Boris Schlossberg, the head of forex strategy at BK Asset Management in New York.
“Net takeaway is that if this is sterilized it will probably not be enough to keep the bond vigilantes at bay. Furthermore, the backing away from any specific yield targets is exactly the lack of clarity that the FX market will not like.”