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Bazooka backfire

5 December 2011 By Neil Unmack

The European Central Bank may be readying its bazooka. Euro zone bond markets are rallying amid hopes that an agreement by European governments on fiscal reform may clear the way for the central bank to start massive bond purchases. But bazookas can backfire.

Ideally, an intervention would create a virtuous circle whereby investors were once again willing to hold peripheral debt. That might allow the ECB to calm markets without actually buying that much.

The Swiss central bank’s move to halt the Swiss franc’s runaway rise in September provides some guidance for a successful intervention. The first ingredient is clarity: the central bank set a rate beyond which it would not allow the currency to rise. The ECB could do the same by making it clear that it will not tolerate bond yields above a certain level.

That level should be low enough to help troubled countries, but reflect the fact that their finances are still shaky. Targeting a spread of, say, three percent above German Bunds would mean fixing the yield on Italy’s 10-year bonds at 5.2 percent – still almost 1 percentage point lower than today.

The second ingredient is credibility. The Swiss central bank’s interventions were credible because they enjoyed political and taxpayer support. The ECB does not have the same cover. Germany’s Bundesbank has openly opposed bond purchases because they take the pressure off governments to adjust their deficits, while many Germans fear that printing money will lead to inflation.

The danger is that the intervention would create a vicious circle. Investors may not believe that the ECB is truly willing or able to buy unlimited quantities of debt – and view purchases as an opportunity to sell. The more bonds the ECB buys, the greater the concern that the central bank might rank ahead of private sector creditors – as it appears to in Greece’s proposed restructuring.

The ECB could limit the scale of its purchases by only buying shorter-dated bonds. Though that might disappoint some investors, it would still do some good because longer-dated bonds would increase in value as they drew closer to maturity.

Whatever form the ECB’s intervention takes, its success will depend on the depth of political commitment to greater integration in the euro zone. The weaker the political cover the ECB receives, the more investors will test it.

 

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