Sunday, 16 September 2012

European Stability Mechanism and ECB's bond-buying offer

The European Stability Mechanism (ESM) is a proposed international organisation which, if established, will provide financial assistance to members of the eurozone in financial difficulty. The ESM is intended to be a permanent eurozone rescue fund, and will replace existing temporary funding programmes- the European Financial Stability Facility (EFSF) and the European Financial Stabilisation Mechanism (EFSM). The present size of the fund is 500billion Euros. It is proposed to locate the ESM in Luxembourg. 1

The ESM will be established if member states which represent 90% of its capital requirements ratify its founding treaty. Of the member-states, ratification by Germany is crucial because it represents more than 27% of the ESM's capital requirements. There was apprehension in Germany about the ESM with a recent poll showing that more than half of Germans wanted the judges to block the ESM. Critics argued that the ESM commits Germany to potentially unlimited funding of debt-ridden eurozone states.However, on 12th September 2012, Germany's Constitutional Court approved the treaty. But the Constitutional Court imposed conditions including a cap on Germany's contribution, which it said could only be overruled by the German parliament. This means a that any future increase in the size of the 500bn-euro (£400bn) fund, or of Germany's contribution, could only be permitted with the express agreement of Germany's parliament.
The Constitutional court ruling paves the way for Germany to ratify the ESM and the associated fiscal pact. This judgement was welcomed by many Eurozone countries and analysts suggest that, combined with European Central Bank plans to buy the government bonds of struggling countries, Europe now had the tools it needed to combat its financial crisis.

ECB's bond-buying offer
The European Central Bank in September 2012 offered to buy the government bonds of struggling eurozone countries in the secondary market.  The ECB wants to help cut the borrowing costs of debt-burdened eurozone members by buying their bonds. The move was introduced by Mr. Mario Draghi (President, ECB). The ECB would engage in outright monetary transactions (OMTs), to address "severe distortions" in government bond markets based on "unfounded fears".
Mr Draghi is hoping that ECB intervention in the bond markets will help reduce the borrowing costs of debt-laden countries such as Spain and Italy and lessen the likelihood of them needing to ask for a full sovereign bailout, an eventuality that could bankrupt the eurozone and cause the collapse of the euro.
OMTs will only be carried out in conjunction with European Financial Stability Facility or European Stability Mechanism programmes. In other words, countries will still have to request a bailout before the OMTs are triggered. Also the OMTs are conditional on a government putting in place financial reforms approved by eurozone financial authorities and monitored by the International Monetary Fund.4

This move was welcomed by markets in Europe and around the world (although opposed by some banks in Germany). Financial Times has dubbed this move as the "strongest signal yet that it (ECB) would deploy unlimited monetary firepower to save the single currency". Many say that the ECB is now taking a more proactive role, akin to the Fed in the United States. 3


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