I’ve already touched a bit on the subject of how the periphery sovereign crisis (and economic recession/depression) impedes the transmission of ECB monetary policy. Since reactivating (in one form or another) the SMP seems like a real possibility i ‘d like to make some comments on how it is implemented by the ECB.

The original idea was quite reasonable: Provide a distressed bond market with a buyer of last resort who has unlimited firepower and can move prices back to equilibrium. Nevertheless, after the Greek PSI, it became clear that the ECB was determined not to accept any haircuts on its claims and would just let its holdings mature with the sovereign having to borrow from other sources (EFSF/ESM or raise taxes) in order to pay maturing bonds, thus effectively subordinating private bondholders and increasing their haircuts.

If the ECB wants the SMP to be effective it must either accept haircuts on its portfolio (at least as large as the purchase discount) or rollover its holdings. If it requires to be paid at par on maturity (by someone else) it does not relieve any pressure on current holders since they are afraid that they will not be paid at par when their holdings mature. As a result, bond purchases only provide an exit strategy for current holders to dispose of their bonds without prices falling too much, a very short-term support for bond prices.

In my view what is needed is for the ECB to act in the same manner as the Fed. Since it regards the SMP as securities held for monetary policy purposes then it should maintain its portfolio as long as the monetary transmission channel is dysfunctional. It could even use the SMP portfolio to match banknotes in circulation, although such a strategy might hurt its profits in the long run (as long as banks have to borrow from the ECB to cover banknote demand). That would require the following:

  1. At a security’s maturity the ECB must place a non-competitive bid for an amount equal to its holdings at the auction of the bond that will rollover the maturing one.
  2. Rebate interest income (interest paid by the security – cost of SMP fixed term deposits) to the issuer. The most straight-forward way is to use the funds to make non-competitive bids in auctions (for bonds of similar maturities).

I know that the above would probably be regarded as monetary financing by the Bundesbank but it is the policy currently used by the Fed which is also not allowed by law to provide overdrafts to the US Treasury or participate in primary auctions as a bidder.

One additional step in the right direction of equalizing bond yields would be to also use the ECB debt certificate idea. The ECB should ‘sterilize’ its purchases by issuing short-term debt certificates. These would increase the supply of short-term safe assets (these mainly consist of zero coupon paper by Germany, Finland, Netherlands and probably France) which are in high demand, especially after the ECB zeroing of the deposit rate. That should probably push AAA short-term securities yields a bit higher by removing their liquidity premium:

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