In exactly one week, on Tuesday, October 14, the Court of Justice of the European Union will commence its long-awaited hearing of the legal challenge to the European Central Bank’s authority under EU Treaty Law to conduct its threatened, but never triggered Outright Monetary Transactions (OMT) bond purchase program.
That challenge, as a reminder, was initially launched in Germany in September of 2012, and heard by the Federal Constitutional Court of Karlsruhe. The FCC ruled that there were many elements of the OMT program that it was indeed uncomfortable with under German constitutional law, but sought clarification of the legality of the program under EU Treaty law by the CJEU in Luxembourg before confirming its reading of the case as it pertains to Germany’s Basic Law (see SGH 2/7/2014, “EU: The FCC’s Punt; a Victory with Real Risks”).
That CJEU judgment is now almost here, and early indications of the ruling, with possible implications for a potential ECB quantitative easing sovereign bond purchase program, may be coming much sooner than markets expect.
*** The “Grand Chambre” of 15 judges of the CJEU is not expected to issue its ruling until early next year, but roughly two weeks after the October 14 hearing, which is on a faster track than general practice, the Advocate General will provide what is called his “avis” (opinion) on the matter. Most importantly, in the vast majority of cases this “avis” tends to provide a very good early indication for which way the eventual final ruling may fall. Markets should also pay close attention to the European Commission’s position in the case – which is also normally made public shortly after the hearing – as a very tight relationship between the Commission’s legal service and the CJEU tends to make the Court extremely sensitive to the Commission’s arguments. ***
*** The CJEU, as the supreme judge of EU law, is not bound to rule precisely on every set of potential EU Treaty breaches outlined in the reference of the case. But the general expectation among legal and political experts is that both the opinion by the Advocate General selected for this case, Pedro Cruz Villalon, a former judge in the Spanish Constitutional tribunal, as well as the eventual final judgment will uphold the ECB’s mandate to propose the OMT. That verdict is most likely to be on the grounds of defending the integrity of the Euro, and therefore through implication, to uphold a widened interpretation of the ECB mandate beyond monetary policy. ***
*** However, and this is a significant caveat, even if the court does as expected rule that the OMT decision does not violate the Treaty and the ECB mandate, and that is not without some risk itself, Karlsruhe has warned that if some of its questions raised last February are not properly addressed, it will take that into account when closing the case before it from the perspective of German constitutional law. An interpretation of the CJEU that purely and simply upholds the act, which Karlsruhe clearly considers ultra vires, is thus likely to trigger a jurisdictional battle that could spill over into the German political arena – and would require political intervention to stem the domestic political repercussions. That would be whether or not the “clarified” OMT indeed represents a potential overreach and unauthorized breach of German fiscal authority and autonomy by the ECB and EU authorities – a separation that is in fact explicitly outlined in the Lisbon Treaty of 2009. ***
*** In order to avert a potential conflict with Karlsruhe and national governments, the CJEU may therefore choose to add some caveats or parameters around the OMT program to ensure that it would not as constructed be seen to be slipping from monetary to “economic” (i.e. fiscal) policy. But the addition of new parameters around OMT would have implications for future programs, and an effort to find a political solution could very well create the risk of a market problem. At a minimum, even if not directly applicable, it would keep alive the prospects of a legal challenge to the much more important Quantitative Easing program of sovereign bond purchases the ECB is weighing and which the markets have increasingly been coming to expect. Indeed, even if a QE challenge is eventually overruled, a caveated CJEU ruling would jeopardize the ECB’s room for maneuver and could even open a challenge to the just launched Asset Backed Securities (ABS) purchase program, already unpopular among more conservative German political circles. ***
In other words, even a favorable ruling from the CJEU runs the risk of either a backlash from Karlsruhe, if too loose in its interpretation, or a backlash from markets, if returned with too many caveats.
The ECB has prepared a strong case for why QE would not violate the EU Treaty’s ban on debt monetization, by considering a QE program structured only in an objective way that would avoid what is being called the “selectivity” problem of deliberately purchasing or favoring one country’s bonds over another. But there are other secondary “breaches” of the debt monetization ban listed in the brief that could also yet prove problematic, and at a minimum even if ultimately addressed, provide additional fodder for future legal challenges to QE.
With a Keen Eye on QE
Strictly speaking, the dispute over the OMT program has zero relevance per se since the OMT program is, for all effective purposes, dead now anyway. Threatened, with a great deal of force and bravado by ECB President Mario Draghi in August 2012, OMT purchases were envisioned to be a powerful yet more thoughtfully constructed successor to the SMP (Securities Market Program) emergency bond purchases that helped stem the collapse of the Eurozone peripheral markets back in 2010-11.
The OMT was a back-stop to Draghi’s emphatic ‘euro is irreversible” statement, reinforcing the pledge to defend the Euro at any cost to keep the Eurozone from falling apart – a tool he never had to deliver on once market spreads started to tighten of their own accord (see SGH 8/3/2012, “ECB: Delivering the Euro Backstop”).
The real relevance of the OMT ruling is of course now in the precedent it will set for the ECB when it comes to launching a potential QE Sovereign bond purchase program – the last effective easing tool it has left in its current toolkit of unconventional monetary policy measures. A less than clean ruling may even be retro-fitted to challenge the more limited Asset Backed Securities (ABS) program just announced, and which is in the process of being rolled out.
ECB officials have been preparing to make the case, as we have written, on one key mandate issue; that QE would not violate an explicit ban in Article 123 of the Treaty on the ECB monetization of government debt or straying into fiscal policy by “selectively” purchasing sovereign bonds.
The key to that argument is that a QE sovereign bond purchase program would in effect only be implemented across the Eurozone on an objective and in fact mechanical basis, and thus by definition with a blind eye to selectively favoring the purchase of one government’s debt over another’s, and as such for purely monetary policy purposes.
The OMT and SMP clearly violated this “selectivity” criterion, but are argued to have been created in order to avoid the break-up of the Eurozone, rather than for debt monetization purposes. They were thus, the ECB states, not intended and did not constitute a stray into “economic” fiscal policy, but were emergency measures that were implemented in accordance with a (slightly expanded) mandate for the ECB – the survival of the Euro.
For QE, by purchasing bonds on an objective “ECB Key” weighted basis, or on, we believe perhaps more likely, a “Market Basket” weighted basis, the ECB would make the case that it is embarking on pure and simple monetary policy for the Eurozone as a whole without deliberately encouraging nor discouraging the behavior of one fiscal authority over another. That would fully address one key “breach” of the debt monetization ban listed in the OMT challenge that is the “selectivity” test, and it is, indeed, a very strong case.
But other objections remain.
A Clever Pre-positioning for a Fight
Even the German Bundesbank’s objections to a QE program have now quietly been shifting from warnings against the violation of the prohibition against debt monetization more to questions over its effectiveness, potential impact on moral hazard, budget discipline, and financial stability.
We suspect Draghi was to some extent anticipating and pre-positioning for this type of objection on effectiveness and moral hazard grounds when he abruptly and explicitly shifted the focus in September of ECB policy from “qualitative ease” – a focus on enhancing the transmission mechanism of its current policies into the real economy through credit policies such as the purchase of SME backed ABS assets for example – to adding an outward policy of “quantitative ease” – balance sheet expansion for the express purpose of pumping stimulus into the system, even if through less direct and inefficient means.
Markets were excited at first by the announcement, but then subsequently became a bit skeptical and confused by the extremely ambitious target for balance sheet expansion Draghi had indicated he had in mind, a roughly one trillion Euro expansion.
This aggressive expansion was and still is purportedly expected to be accomplished through the take- up by banks of ultra-cheap, four year TLTRO (Targeted Long-term Refinancing Operations) loans and the purchase of bonds through the newly launched ABS program.
But that plan ran right out of the gate into a very weak 82 billion Euro take-up of the first, September 18, TLTRO tranche, combined with continued frustration and roadblocks in getting European governments to help stimulate the ABS program. Fiscal authorities have so far stubbornly refused to use (their) tax-payer money to guarantee lower, mezzanine, tranches of ABS bonds in order to enhance the credit ratings for that market, which would allow the ECB to buy those for their balance sheet, in addition to the higher rated senior tranches.
Despite assurances from ECB officials that they expect the December 11 TLTRO tranche, coming after the conclusion of the Asset Quality Review of banks’ balance sheets and closer to year-end, to be better received, those initial challenges clearly highlight the difficulty the ECB will have in expanding its balance sheet by as much as first suggested under its current plan – especially in any reasonably timely fashion.
Draghi thus went notably out of his way in last week’s ECB press conference to distance himself from that explicit balance sheet expansion target, reminding markets that the balance sheet is just a means to the ultimate end – and true objective – a 2% or just under inflation rate.
But, he is now also cleverly positioned, if all else fails, to point to the one additional source of balance sheet and monetary policy expansion left if needed, and that is a sovereign bond purchase program.
The OMT court case could, however, even if resolved favorably, yet still continue to cast a shadow over the ECB’s ability to go much further down that road.
The Long List of “Breaches”
With that in mind, we have learned there is a long list of Treaty “breaches” outlined by the Federal Constitutional Court in the case, a number of which if upheld could impact QE and even an ABS program, in addition to the critical test or issue of “selectivity” used in determining whether QE would constitute monetary financing or not.
The CJEU is first of all asked to consider these breaches in case an OMT is triggered. The German Federal Constitutional Court in February, however, in order to avoid a possible CJEU technical punt on the matter (“we can’t judge on the OMT because it is not indeed a Decision formally adopted by the ECB”), also asked the Luxembourg Court to consider the case even if the OMT is never activated, but simply as currently proposed.
At issue is namely: “Does a transgression of the European Central Bank’s mandate follow in particular from the fact that the [OMT] Decision of the Governing Council of the European Central Bank of 6 September 2012…[paraphrasing the breaches for clarity, with comments, below]:
– Has “conditionality” in being linked to the ESM and EFSF (in other words, is in effect attached to fiscal policy – this could theoretically apply to QE if the ECB, ironically, is accused of leaning too strongly on linking its purchases to whether a country is in a program or not)
– Has “selectivity” in choosing one country over another (this is a critical test for monetization of fiscal policy, discussed above, that would not apply to a QE program as envisioned, which would be based on an objective implementation criterion across Eurozone countries)
– Has “parallelism” coming on top of EFSF and ESM programs
– Has “bypassing” in potentially undermining the fiscal policy efforts of EFSF/ESM (this could translate into a clear link to the fiscal ”moral hazard” issue of QE buying bonds of countries that are in violation of the fiscal compact, or at a minimum accusations that QE would be a disincentive to sound fiscal policy and reform)
– And specifically in regards to the risk of monetizing debt, does not envisage quantitative limits for the purchase of bonds (this “volume” issue could be a clear problem for both QE and ABS if the policies are deemed to cross the fiscal as well as monetary realm)
– Does not envision a time lag between the emission of bonds on the primary market by governments and their purchase on the secondary market (this could lead to a challenge to the ECB right to buy bonds in the secondary market, but the ECB could avert this problem by avoiding purchases of bonds right after issuance. The FCC is, however, sensitive to the risk of abiding by the letter of the law that allows the ECB to purchase sovereign bonds on the secondary market, while circumventing the intent of the ban on debt monetization if evidenced under other metrics)
– Allows for all bonds to be held to maturity (this is a “market interference” monetization challenge – in effect that you are permanently distorting a market for government bonds in favor of the issuer by taking these bonds out of the marketplace for ever – and relevant to QE.)
– Contains no specific credit requirement, and has default risk (this can be addressed, but not eliminated)
– Envisages the equal treatment of European System of Central Banks (National Central Banks) in case of a debt cut (this was a major issue during the Greek bond restructuring, and it is calling out the ECB for pressuring the NCBs to take a haircut on their bond holdings along with the private sector participation even though the ECB did not haircut its own bonds and the NCB actions were presented and deemed to be purely “voluntary.” A haircut is argued both as a potential ECB “imposed” fiscal cost, and a potential “reward” to the deadbeat issuer – monetization).
The “breaches” pertaining to unlimited and unclear volume and risk exposure, potential default, and credit risks could be extended to questioning whether a QE and ABS program would be an EU level increase in the fiscal risk of the sovereign country. They are also perhaps the most significant and sensitive in pertaining to the German Constitution, and with it, the Federal Constitutional Court in Karlsruhe.
Karlsruhe has suggested some ways in which the OMT program could be brought in its view in compliance with the violation against the unauthorized monetization by the ECB of debt – namely with a cap on the amount spent, a pledge not to haircut the bonds it purchases, and, most subjective of all, and avoidance of interference in market price formation “where possible.”
The overarching objective is to have a program that can be supportive, but does not interfere with fiscal policy objectives. While not all those conditions, if met, would be directly applicable to a potential QE program, they would certainly provide fodder for a future challenge.
Overall, the pressure on the European Court is enormous: the German Federal Constitutional Court offered a real curveball in forcing the CJEU to take a stance. It either steps out and defends the ECB tout-court, potentially creating a conflict with Karlsruhe and indirectly helping the anti-Euro Alternative for Deutschland party in its case against Chancellor Angela Merkel’s Euro-stance, or it accepts the limitations proposed by the German court.
Accepting limitations could not only undermine the effectiveness of a QE program, but more broadly also once again revive the 2012 anxiety over the ultimate path of the single currency, especially if countries are deemed to be “masters of the Treaties” (as per the German Federal Constitutional Court, 2009 judgment on the Lisbon Treaty), with the continued ability to slow and even reverse the course of integration.