In the first week of September the European Central Bank lit the EUR/USD on fire with its latest acronym to save the euro – OMT, short for “Outright Monetary Transactions.†For most investors, OMT is just another ingredient in the central bank’s alphabet soup which already includes SMP, EFSF and ESM, but this one has been enough to drive the EUR/USD to a 4 month high. If you are wondering just why economists and investors are so excited, read on because in our education center, we always attempt to explain relevant concepts in a simple manner.
Lets start by breaking the words down:
Outright – An outright program pertains to a program that is open, direct and without restrictions
Monetary – Monetary basically refers to providing money or funds
Transactions – Through “Transactions†or deals in the market
For the ECB in particular, these outright monetary transactions involve buying government bonds in the secondary bond market. Here’s the way it works:
Step #1 – Country X admits that it has a problem and needs help by officially asking the European Union or the International Monetary Fund (IMF) for help.
Step #2 – EU and/or IMF agree to help and lay out the deficit reduction terms that Country X must abide by. There are 2 programs that would qualify. Program 1 is a “full macroeconomic adjustment program,†similar to what Portugal, Ireland and Greece have. Program 2 is a less stringent “precautionary program†which is like a line of credit and would be terms more agreeable to a country like Spain or Italy.
Step #3 – Country X agrees to the fiscal reduction program and ECB moves forward with buying short term bonds (3 years or less) of Country X to keep yields and borrowing costs low, making debt service more manageable for the country.
Additional Details:
1. Unlimited Purchases – OMT is unlimited, which means that the central bank would provide an open ended commitment to continue buying the country’s bonds as long as they continue to adhere to terms. OMTs replace their previous SMP or Securities Market Program which was limited and temporary
2. Sterilization – Bond purchases will be sterilized which means they will fully offset their purchases by selling other securities such as Treasury bills to neutralize the impact on money supply. By doing this, the ECB avoids going down the path of quantitative easing which involves creating new money
3. Seniority – Draghi said the ECB will be “pari passu†with other creditors. Pari passu is a Latin phrase that basically means on equal footing so effectively the central bank will be giving up its seniority to convince bond holders that if they invest in highly indebted nations, in the event of a default or debt restructuring the ECB will not stand in front of them in line to be repaid.
Very nice articles, thank you.
I don’t think it’ll work for the long run. Injecting money into the system often worsens the problem. Not to mention limitless injections. This method will only make the situation worse. With austerity, many European nations have already suffered badly. While they’re proposing unlimited purchases, there are also a set of rules that European nations needs to comply – cut spending; and it’s a no brainer to assume that each set of austerity will become more stingy than the last while each nation’s debt piles up. No country can thrive with basics benefits been taken away. They’re creating even a bigger ‘black hole’ where monies been thrown in and nothing comes out.
Kathy , Thanks a million for all your Info. Hope you had a great weekend. 🙂
Ryan
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ECB Outright Monetary Transactions | BK Asset Management? We really want to read through
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