The European Central Bank had announced their new bond purchase program, earlier in September in an effort to save the Euro currency. ECB Chief, Draghi called it the “Outright Monetary Transactions” or OMT for short. Immediately upon announcing his plans, the EUR surged to a four month high against the USD. So what is the ECB’s OMT and how will it help the Euro? Here is an explanation on the program and why the announcement has made the markets more optimistic.
The OMT, is a monetary program that provides money or funds to Eurozone nations that are currently struggling with their debts. OMT is an open ended program and does not have any restrictions or limits. It involves the ECB to purchase government bonds in the seconday markets. As you might know, a sovereign government/nation issues bonds in order to raise money. When a country’s credit rating is in the negative, it makes the bond purchases risky, thus resulting in a higher interest rate. At times, things can go so bad that the interest rates skyrocket, making it almost impossible for the government to sell the bonds.
By intervening, the ECB purchases these bonds in order to drive down the interest rates and thus make it easier for such debt ridden countries in the Eurozone to issue government bonds and thus raise money to meet their deficits in the budgets.
How does the ECB’s OMT work?
In order for the ECB to engage in Outright Monetary Transactions, the first step is for a Eurozone country to apply for financial assistance. Meaning that the country needs to realize that it has a financial crisis looming and thus requests the EU or the IMF to seek financial aid. After scrutiny of the country’s financial books, the EU/IMF decides if the country in question does indeed require financial assistance. Once approved, the EU/IMF prepares a plan for deficit reduction, which the country must follow. Also known as austerity measures in order to reach a target growth level.
Within the OMT, there are two programs. The first is known as the full macroeconomic adjustment, which in the past included countries like Portugal, Ireland and Greece. The second is known as the precautionary program which acts as a line of credit which is what countries like Spain and Italy will eventually hope for.
Once the formalities and plans are agreed upon, including the fiscal reduction, the ECB proceeds with purchasing short term bonds (3 year maturities) from the country and drives down their bond yields, thus pushing the interest rates lower and making debt more manageable for the country.
Key Features of ECB’s OMT
The European Central Bank’s OMT has certain key features built into it. Firstly, there is no limit on the purchase. This means that the ECB provides an open ended commitment to buy the country’s bonds so long as the country sticks to the course of the agreed plan for fiscal reduction. The OMT works on the opposite principle to that of aa Securities Market Program or SMP which was limited and temporary.
Bond Sterilization was another key point mentioned. This basically means that when the ECB purchases Bonds, they are sterilized. To offset their purchases, other securities are sold so as to keep any impact on money supply to a minimum and thus results in avoiding future quantitative easing programs or printing new money.
Bond seniority is an important element of the ECB’s OMT plan. This infers that all creditors are on equal footing with the ECB. So when the time comes for the bond holders to be repaid or if there is a case of default or restructuring of debt, the ECB will not be the first creditor to get its money back but rather other creditors are given preference.
Critics of the OMT say that the above program is not fool proof to help push the Eurozone out of the crisis but is seen more as an effort to buy more time. The ECB of course, will simultaneously engage in other monetary tools at its disposal in order to fix the fiscal crisis.
The biggest obstacles, the ECB faces at the moment is in creating a banking union which will enable it to implement reforms evenly across all the regional, sovereign central banks, something which has been met with a lot of opposition.
While the OMT has managed to save the Euro, the larger question that is on everyone’s mind is until when.