One of the main decisions of the recent Euro summit was to make the ESM a ‘market participant’ which can intervene in sovereign bond primary and secondary markets (although details have not been laid out yet), a commitment that was mainly requested by Italy. Although it will seem strange, i am not in favor of this idea, given the current ESM structure.

In the case of central bank liquidity operations there are basically two alternatives. In the first, the central bank calculates the banking sector’s liquidity needs (mainly due to reserve ratios and autonomous factors) and provides the calculated amounts at a given lending rate. Any excess needs (which should be small) are covered by use of the marginal lending facility. This mechanism provides for precision on the interest rate target and tight control of the central bank balance sheet but requires that private money markets are working smoothly and all participant institutions have equal access to liquidity (with haircuts on collateral and credit spreads on counterparties compensating for risk).

The other alternative is to provide liquidity with full allotment and act as a ‘market maker’ in times of acute market stress. The central bank balance sheet will expand according to market needs and control of the interest rate is limited, with movements mainly constrained by the central bank corridor system (deposit facility – marginal lending facility). Still, the credit system can continue to function without breaking down, as would happen if the central kept providing liquidity using the first mechanism.

One can evaluate the ESM using the above framework. The current ESM scheme basically resembles mechanism no. 1. It can be used as a bank recapitalization – deposit insurance mechanism and a general backstop in good times. Since its ‘cost of capital’ is high, seniority is important. In bad times, a buyer/lender of last resort must have complete balance sheet expansion flexibility in order to be credible. That means that the ESM should have a banking license (to be able to leverage with the ECB) if it were to participate in the sovereign bond market as a buyer.

I ‘ve already posted a table with holders of Italian debt, based on available official data. I ‘m reproducing it here:

It is clear that during the period of Oct-2011 – Feb-2012, non residents reduced their holdings of Italian debt by more than €80bn to a bit over €700bn. This was compensated by an increase from domestic MFIs (€40bn) and other residents (€50bn). The increase in holdings by residents was financed by the two 3Y-LTROs by the ECB and it is quite possible that it has reached its limits in terms of balance sheet exposure by domestic institutions. Lowering their exposure by another 10% is not something remote for non residents, given the current quality of Italian macro. In addition, foreigners also decreased their exposure to Spanish government debt by €37bn in 2011Q4 and 2012Q1.

The possibility that the ESM will have to act as a buyer of last resort for almost €100bn of Italian and Spanish sovereign debt within the next months is far from negligible. Given the existing commitment of €100bn for Spanish banks recapitalization, such ‘market making’ would eat all ESM available capital, since (with current schedule that i am aware of) paid-in-capital will be €32bn between July 2012 – 2013 and ESM lending capacity limited to €210bn.

In my view, current sizes are just not credible. Secondary market bond buying should be left to the ECB (although that leads to bond holders subordination in a future PSI) or the ESM should become a bank. Otherwise, the market will test the commitments and given current RoW holdings, the fight will be quickly lost.

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