ECB’s Outright Monetary Transactions (OMT)

A new stimulus program was announced by the European Central Bank in the first week of September.
This program to save the euro is called “Outright Monetary Transactions” or “OMT” and it was enough to drive the EUR/USD to a four month high.
Here’s an explanation of the program and why economists and investors are so excited.

  • Outright – an outright program pertains to a program that is open, direct and without restrictions
  • Monetary – monetary basically refers to providing money or funds
  • Transactions – through “Transactions” or deals in the market

For the ECB in particular, these OMT’s involve buying government bonds in the secondary bond market.

Here’s the way it works:

At first, a country admits that it has a problem and needs help by officially asking the EU or the International Monetary Fund (IMF) for help.
The following step is the EU and/or IMF agrees to help and lay out the deficit reduction terms that the country must follow.
There are two programs that would qualify, The “full macroeconomic adjustment program” similar to what Portugal, Ireland and Greece have, or the “precautionary program” which is like a line of credit and would be terms more agreeable to a country like Spain or Italy.
Lastly, the country agrees to the fiscal reduction program and ECB moves forward with buying short term bonds (3 years or less) of the country to keep yields and borrowing costs low, making debt service more manageable for the country.

Other details of the program:

  • Unlimited Purchases – OMT is unlimited, meaning that the ECB would provide an open ended commitment to continue buying the country’s bonds as long as they continue to adhere to terms. OMT’s replace their previous SMP or Securities Market Program which was limited and temporary.
  • Sterilization – bond purchases will be sterilized, which means they will fully offset their purchases by selling other securities to neutralize the impact on money supply. By doing this, the ECB avoids going down the path of quantitative easing, which involves creating new money.
  • Seniority – Mario Draghi said the ECB will be “pari passu” with other creditors. That is a Latin phrase meaning “on equal footing”, so effectively the ECB will be giving up its seniority to convince bond holders that if they invest in highly indebted nations, in the event of a default or debt restructuring the ECB will not stand in front of them in line to be repaid.

This program, after all, is not likely to save Europe.
The ECB is still using monetary tools to solve fiscal problems.
That is, its lending to those who need to cut debt and spending.

What Europe needs is a real fiscal and banking union along with a convincing plan to promote growth.
These are unlikely to happen before one or more sovereign defaults ignites a crisis.

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