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Draghi’s Grand Plan to Save Euro Wins Over Markets, For Now

09.07.2012

Mario Draghi’s ambitious rescue plan to hold the eurozone together continues to be well received by the markets, despite reservations from Germany.

In early morning European trading today, a bond rally had given a boost to the struggling Mediterranean members of the 17-nation eurozone. For instance, Spain’s 10-year bond yield, the benchmark measure of borrowing costs, fell below 5.7% this morning—the first time it had been below 6% since May and down from the 7.6%, deep in the ‘7% danger zone’ where borrowing costs are unsustainable, it was at just six weeks ago. Italy’s 10-year bond yield, too, had slipped to 5.15% from 5.32% overnight.

Asian markets have also rallied today on the European bond-buying announcement with China’s Shanghai Composite rising 3.7%, Hong Kong’s Hang Seng gaining 3.1%, South Korea’s Kospi increasing 2.6% and Japan’s Nikkei realizing gains of 2.2%.

Draghi, the head of the European Central Bank (ECB), yesterday sought to ease the euro crisis with his much-anticipated bond-buying program announcement, which he called the emergency Outright Monetary Transactions (OMT) scheme. Under the proposals, the ECB can now make unlimited purchases of troubled euro debt but they will have to be bought on secondary markets rather than directly from governments.

The purchases will also be sterilized; in other words, it will not amount to quantitative easing, or merely ‘printing money’. However, in order to qualify, countries must be in the European Financial Stability Facility (EFSF) or European Stability Mechanism (ESM) bailout programs to get the assistance. Spain, for instance, does not currently meet these criteria and, if it were to do so, would have to agree to stricter austerity programs to cut its debt.

Draghi pushed through the measures despite fierce opposition from Germany’s central bank, the Bundesbank.

“We say that the euro is irreversible,” said Draghi at the ECB’s Frankfurt headquarters yesterday. “OMTs will enable us to address severe distortions in government bond markets which originate from, in particular, unfounded fears on the part of investors of the reversibility of the euro.”

The ECB wants to intervene in the government bond markets to narrow the gap between the low interest rates of safe haven countries such as Germany and the unsustainable costs faced by some struggling southern European nations. But Germany, in particular, is fearful that the OMT will lead to taxpayers across Europe paying the price of more profligate countries.

“The main news from yesterday’s speech and press conference was in fact less about the practical details of the Outright Monetary Transactions but its purpose: not merely to target a specific yield on Italian or Spanish bonds but to address the ‘unfounded fears of the reversibility of the euro’,” Yannick Naud, portfolio manager at Glendevon King Asset Management, a fixed income boutique based in London, told Markets Media.

“Therefore it is more likely to be much more potent than the now defunct Securities Market Programme from previous ECB head Jean-Claude Trichet, which at the time was seen either to small or ineffectual.”

Germany’s top-selling newspaper Bild today claimed the move by the ECB was tantamount to Draghi signing a ‘blank cheque’ and that the measures had gone too far. Some traders have also started referring to OMT as ‘On My Tab’. While other market analysts believe that the bond-buying scheme has merely just earned the European Union some much-needed time and is not a solution to the eurozone crisis as it is not sufficient, in itself, to end recessions and reduce deficits.

But other had high hopes for the announcement.

“We strongly welcome the ECB’s new framework, the Outright Monetary Transactions, for intervention in sovereign bond markets of countries accepting EFSF and ESM support for their macroeconomic adjustment programs and adhering to the associated structural and fiscal reform efforts,” said Christine Lagarde, managing director of the International Monetary Fund (IMF).

“The IMF stands ready to co-operate within our frameworks. Decisive implementation of the new intervention program will help repair monetary transmission, and support countries’ efforts to secure finance at a reasonable cost while they undertake sustained macroeconomic adjustment. We see the ECB’s action as an important step toward strengthening stability and growth in the euro area.”

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