An account of how the European Central Bank managed to keep the Eurozone together

Gibran Watfe, 14 September 2015

It was an unusual Monday morning on May 10th, 2010 in Frankfurt. During the weekend, the heads of state, the president of the European Commission and the president of the European Central Bank were hastily looking for a solution to the imminent euro crisis, before markets would open on Monday morning. It must have been a stressful morning for the ECB staff in DG Market Operations, because it was the day when the ECB announced that it would buy large amounts of government bonds from troubled Eurozone countries in the framework of the Securities Markets Programme.

The problem that the ECB faced was an increasing fragmentation of financial markets. Until then, financial markets viewed the sovereign bonds of Eurozone countries as carrying the same risk. Prices (i.e. yields) were practically the same across all the members of the Eurozone. However, suddenly investors started to look into the risks of each of the Eurozone countries and began factoring in significantly different probabilities of default. The result was a dramatic increase in yields of Greek, Irish, Italian, Spanish and Portuguese bonds. Higher yields represent higher refinancing costs for the governments. This created a vicious circle. These countries would find it even harder to find new liquidity on the markets because they would have to offer higher interest to attract buyers for their bonds and that, in turn, would make servicing of their debt more expensive, bringing them closer to the edge of default.

Harmony and fragmentation

Source: Author calculation based on Datastream

Greek sovereign bond spreads. Source: Datastream

Why is the ECB concerned about financial fragmentation? Usually, measures to combat increased fragmentation are justified by the need to restore the monetary policy transmission mechanism. For the ECB being an effective monetary policy executor, the financial markets across countries need to be aligned. In the particular situation in May 2010, however, what was more urgent was to keep the troubled Eurozone governments solvent. Not acting was therefore not an option for the Governing Council of the ECB. The fragmentation of financial markets can be summarized in a single indicator. Sovereign bond spreads demarcate the difference between a country’s sovereign bond yield and the bond yield of a country that is considered to be relatively risk-free. German government bonds were considered to be almost risk-free, thus they were taken as the benchmark against which other yields would be measured. The sovereign bond spreads thus capture the level of fragmentation within the Eurozone, or conversely,  the degree of integration of financial markets.

For the purpose of preventing further fragmentation of financial markets, the ECB had two options. First, the ECB could buy high-yielding government bonds directly in the secondary market. The market participants consequently would sell high-yielding bonds and re-balance their portfolios with lower-yielding bonds.[2] This would make yields more similar, i.e. drive down the spreads. Second, the ECB could act more indirectly by saying it will do anything that would be needed to keep the Eurozone together. With the huge potential firepower (read: the monopoly of printing money), investors would ideally take this as a credible signal and start adjusting their portfolios based on this information.

And in fact, the ECB used both strategies during the crisis. Under the Securities Markets Programme in 2010 and 2011, the ECB bought more than 200 billion worth of distressed government bonds and thus induced investors to re-balance their portfolios. The announcement by Mr. Draghi to do “whatever it takes to save the euro” and the subsequent ad-hoc design of the Outright Monetary Transactions programme in 2012 credibly signalled to investors that sovereign bonds of Greece, Italy, Spain, Ireland and Portugal were not that risky after all.

This is a good story but the question that arises is whether it is borne out by the facts.[3] Did the ECB programmes have an impact on sovereign bond spreads? Or in more political terms, did the ECB manage to keep the Eurozone together by adopting its asset-purchase programmes? After all, a single buyer can only move prices in the markets if it has pockets that are deep enough. By any measure, the 200 billion SMP, the 1,100 billion PSPP and the (theoretically) unlimited OMT were sizable. It is worthwhile to ask whether this vast amount of money had the desired effect.

Event studies to gauge impact

Source: Author calculation based on Datastream

My lens was good enough to capture most of the movements of spreads. Source: Author’s estimations.

One way of looking at movements in financial markets is to perceive each piece of new information as a distinct event at a specific point in time. The literature that takes this perspective is thus referred to as event studies. I looked at two sorts of events in particular. Firstly, those days when the ECB started each asset-purchase programme. Secondly, the days on which an asset-purchase programme was announced. Then I looked at the movements of sovereign bond spreads around these dates with the help of a particular lens (i.e. a model) that filters out any other factors but the ECB’s measures that were responsible for movements in the spreads.

And it turns out that indeed the ECB had a substantial impact on the sovereign bond spreads with many of its asset-purchase programmes. Interestingly, the announcements of the ECB had larger effects than the actual purchase of sovereign bonds. Thereby, the Securities Markets Programme was the most effective in reducing spreads and hence restoring harmony in the financial markets across the Eurozone. The analysis also included the most recent full-blown quantitative easing programme of the ECB. The effects that I found using my particular lens were negligible. This is explained by the nature of the programme that has other targets than reducing financial fragmentation. After using the lens to look at the events, I performed a sensitivity analysis to check its stability in different conditions. In most of these conditions, my lens proved to be stable and thus my results became more reliable.

As they alone move markets, Mr. Draghi’s word are rightly weighed like gold by market participants. In crisis situations in particular these words alone can determine whether the Eurozone stays intact or not. Still, those buying the bonds on that Monday morning in 2010, the staff at DG Market Operations, were ultimately the ones who, despite their distinct motives, kept the Eurozone together at a very crucial juncture of European integration.

[1] This article is based on my thesis “The impact of the ECB’s asset purchase programs on sovereign bond spreads in the Euro area”.

[2] The price of a bond is inversely related to its yield. By buying the bonds, the ECB increased the demand, raised their prices and reduced their yields.

[3] The purpose of my Master’s thesis was indeed to test empirically the impact, if any, of the ECB’s programmes.