LONDON (Reuters) - Unless the European Central Bank sets no limits on its purchases of government bonds to lower struggling countries’ borrowing costs, some investors may see any intervention as a chance to sell, threatening the success of the bank’s plan.
Doubts over whether the ECB’s latest crisis-fighting scheme will be aggressive enough, in terms of both volume and duration, to contribute to solving the debt crisis could see foreign investors in particular simply sell down some of the more than 900 billion euros of Spanish and Italian debt they still own.
Past experience, when the ECB hesitantly bought up shunned government bonds in 2010 and 2011, suggests that any hint that the new window is open only briefly or for limited amounts may have investors piling in to dump paper on the bank.
For now, the market expects much more. ECB President Mario Draghi’s pledge to save the euro has created anticipation of a massive new program of Spanish and Italian bond purchases. Even before details are announced, Spain’s two-year borrowing costs have halved and Italy’s cut by more than a third.
Details of the plan, which is likely to focus on buying shorter maturities, are expected to be fleshed out on Thursday. But many doubt it will lead to a permanent fix to the euro zone’s troubles, with investors still demanding unsustainable rates to lend to Spain and Italy over 10 years.
“If you believe that the ECB support will give only temporary relief and after the temporarily relief, we will go back to wider spreads, to a downgrade, to further risk, then the best (option) is to sell,” Alessandro Giansanti, senior rates strategist at ING, said.
“The intervention of the ECB has to be very massive in terms of size so you can have a 200 bps fall in yields,” he added.
The ECB hopes its actions will reverse the steady sell-off of strained countries’ bonds over the last few years by all but local banks and investors, which has helped drive yields higher.
Data from the Bank for International Settlements shows that over 2011, as the crisis intensified, non-European holdings of Italian and Spanish bonds fell 35 and 30 percent respectively, with domestic investors having to pick up the slack.
Italian data shows the share of its bonds held by foreign banks and investors stands at around 40 percent while a comparable figure for Spain is a little under 30 percent.
The past sell-off may have limited the potential for a further rush to the exit once the ECB starts buying. But non-resident investors still own over 700 billion euros of Italian debt and about 200 billion euros of Spanish debt.
That said, it is unclear how much foreign investors own of the shorter-dated paper most likely to be bought by the ECB.
Foreign investors used the ECB’s Securities Markets Programme, when it bought 70 billion euros of Greek, Portuguese and Irish bonds and then, in late 2011, 150 billion euros of Italian and Spanish debt, to bail out of risky exposures.
So while that exercise cut the yield spread of 10-year Spanish bonds over German Bunds to 272 bps from 401 in just four days, that premium demanded by investors has since rebounded to 523 bps.
However, Draghi’s recent comments were his boldest yet on central bank support, and he has won tacit backing from German Chancellor Angela Merkel for the scheme, even though it still faces opposition from other German officials.
Whatever the conditions are for renewed ECB purchases, there are reasons for euro zone banks to resist selling and hold on to their bonds: they can use them to take out cheap ECB loans; and selling now may mean locking in past losses and missing out on future capital gains just as end-year results are coming up.
New regulations giving banks more incentive to hold sovereign debt may also counter any temptation to sell out.
However, many investors remain skeptical of any long-term improvement in Spanish and Italian bond prices.
Jack Kelly, investment director of global government bonds at Standard Life Investments, said the $247.1-billion fund was underweight both sovereigns, thinking any bond-buying would help bring down yields but only for a limited period.
Kelly believed the central bank may only make purchases in conjunction with the euro zone’s rescue funds, either the European Financial Stability Facility (EFSF) or its successor the European Stability Mechanism (ESM): “And the buying power of the EFSF and ESM is limited,” he said.
Policymakers are keen to keep international investors on board. They are concerned that, while having a state’s debt held by a concentrated national group may offer short-term stability, it raises systemic risks by binding more closely together the fates of governments and commercial banks.
Early signs have been encouraging. China’s Premier Wen Jiabao said on Thursday China was willing to continue buying euro zone sovereign debt.
Since Draghi’s pledge on July 26, the cost of insuring against a Spanish or Italian default has fallen sharply. Spain’s 5-year credit default swaps are down from more than 630 basis points in late July to below 500, according to Markit data.
But the rationale for sellers is also clear. The hope of ECB purchases has pushed up the prices of shorter-term Spanish and Italian bonds, even though the underlying economic fundamentals and governments’ abilities to pay their debts have not changed.
At Societe Generale, global head of economics Michala Marcussen, concluded: “This is not going to be the silver bullet that ends the euro zone crisis.”
Additional reporting by Laurence Fletcher, graphics by Scott Barber and Vincent Flasseur