Another Great Shorting Opportunity

EUphoria has broken out again with the ECB announcement that it would engage in “unlimited” buying of short term (maturities<3 years) Spanish, Italian, etc., debt . . . under certain conditions.

The crucial condition is that the beneficiaries of Mario’s largesse formally apply for and receive assistance from the EU’s bailout mechanism, the European Stability Mechanism (ESM).  Since this assistance comes with conditions, all of the political and credibility issues are still in play.  The game of chicken between the mendicant countries and Germany will continue.

My read on this announcement is as follows.  Over the past year plus there has been concern that the ESM and its predecessor the ESF did not have sufficient funds to save a big country like Spain.  So there were all sorts of plans mooted to lever ESF/ESM resources.  The most recent included a proposal to give the ESM a banking license, allowing it to borrow from the ECB, thereby permitting it to lever its capital.  This proposal foundered on German opposition.

The ECB announcement seems crafted to achieve the same objective.  Instead of the ESM providing higher levels of funding to Spain, etc., by borrowing through the ECB after negotiating bailout conditions, the ESM and the ECB will work in parallel.   The ECB will effectively lend directly to the bailed out instead of lending indirectly through the ESM.  So both alternatives involve conditionality and the use of ECB resources to supplement ESM resources.

The allocation of credit risk may well be different under the two alternatives, but I haven’t had time to sort through that.  That issue is likely to be crucial, though, and impact negotiations between the ESM and the countries requesting assistance.  The ESM and the countries that fund it (I’m looking at you, Angela!) know that an ESM bailout will get the ECB involved, and that involvement will create credit risk and the potential for monetization.  These countries will take that into account when deciding whether to provide support and the conditions under which it is provided.

Meaning that fundamentally things haven’t changed all that much.  The crucial issue is still the political dynamic between the countries with the money and the countries that need it.  Draghi hasn’t changed that problem one bit.  Indeed, he has just raised the stakes in the negotiations, making them all the more fraught and complicated and less likely to succeed.  Levering up the ESM (whether directly or indirectly) also levers up the risks, stakes, and complexity in any negotiation.

Which means that in my opinion, as with most “solutions” proffered up by the Euros, this is a great shorting opportunity.  It hasn’t changed the fundamentals in Spain, which are getting worse by the day.  It hasn’t reduced the fundamental difficulties (moral hazard, credibility and crucially distributive effects) associated with any bailout.  Which means that when Spain is in extremis, which seems inevitable, a deal will be very hard to accomplish, especially in light of bailout fatigue in Germany.  In other words, the ECB action affects the outcome conditional on achieving a bailout agreement, but crucially it also affects the likelihood and terms of such an agreement.  The market has focused on the first issue, and is ignoring the second.  But I think that the second is fundamentally far more important.

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