Government bonds and collateral the ECB received for similar operations will decrease in value and thus the ECB’s capital will shrink.

Right after the 2001 crisis, the Central Bank of Turkey (CBT) purchased large amounts of government bonds. This operation was possible mainly because the government back then had initiated the stability program which focused on fiscal and monetary discipline and planned a substantial and favorable change in the banking sector. The program was supported by a large IMF funs with suitable terms. 

The ECB asks for guarantees

The European Central Bank (ECB) on the other hand is not able to carry out a similar operation that will save time and relieve financial markets to a large extent until the results of the program troubled countries have been implementing are unearthed. There is a simple reason for this: the ECB is not the national central bank of Spain or Italy. It is the central bank of the entire Eurozone. Countries of the region, Germany and Finland to begin with, ask for a guarantee that Italy and Spain will stick to the terms of the current economic programs. With Germany’s weight in the zone, the ECB has no option but follow them.

This is why the ECB asks for a guarantee that the countries will stick to their economic programs. The “guarantee” in the ECB’s mind works as follows: It agrees to purchase bonds on the condition that Spain and Italy apply to the stability funds: the current fund, the EFSF, is the temporary one. The ESM that will replace the EFSF and will have a larger amount of capital is not active yet. These funds are authorized to lay certain economic terms on applicant countries. If the applicant country agrees with the terms, the relevant fund or mechanism directly purchases the Treasury bills of the applicant country. The ECB plans to make purchases further, later.

There are a couple of critical challenges, however. Chief among these is that, the ESM, is not active yet. A group of politicians, academics, NGO representatives and “the men on the street” have applied to Germany’s constitutional court for the annulment of the parliament decision against the establishment of the ESM. Their motion proposes important justifications on why the parliament decision shall be annulled. The court is to reach a verdict on September 12^th. If it approves the parliament’s decision, the ESM will not be launched. This would be a huge blow on the troubled countries and on the future of Eurozone.

Problems will prevail even if the court decides to grant an injunction against the parliament’s decision and the ESM is launched. The Bundesbank has recently declared that the ECB cannot independently decide to purchase bonds as this will violate EU laws and thus such operation shall be approved individually by the parliaments of member states. So, here is an optimistic scenario: assume that this hurdle was cleared. Yet, it is not likely that the ECB can make a purchase sufficient to relieve Spain and Italy: in the occasion that Spain and Italy fail to fulfill the economic programs in place, government bonds and collateral the ECB received for similar operations will decrease in value and thus the ECB’s capital will shrink. This means, the ECB’s shareholders will face large losses. And as the largest shareholder, Germany will be the one who carries the can. Of course, Germany is not the only country trying to avoid the damage. Finland is also in the queue. Under these circumstances, imposing a limit on quantity comes to the agenda as an “interim solution.”

This commentary was published in Radikal daily on 30.08.2012