With plans for the EFSF floundering, there are increasing calls for the ECB to buy large quantities of Italian sovereign debt in an attempt to reduce Italian bond yields and retain Italy’s access to the primary debt market. For example, Portuguese President Anibal Cavaco Silva called last week for the ECB to act as a lender of last resort with a “foreseeable, unlimited intervention.”
While these calls are understandable given the current circumstances, recent indications suggest these calls are falling on deaf ears. Regardless of the various economics arguments for and against the ECB adopting a role as lender of last resort for Member States, there appear to be compelling legal issues arguing against this, beginning with the statute that enabled the European System of Central Banks.
The Statute of the European System of Central Banks (ESCB)
The Statute is a protocol attached to the Maastricht Treaty, agreed in February 1992. Article 18(1) of the Statute permits the ECB and the national central banks of the eurosystem to purchase securities to achieve the objectives of the ESCB, while Article 18(2) gives the ECB the ability to establish principles governing these purchases. These Articles are fairly short and are worth repeating here.
Open market and credit operations
18.1. In order to achieve the objectives of the ESCB and to carry out its tasks, the ECB and the national central banks may:
— operate in the financial markets by buying and selling outright (spot and forward) or under repurchase agreement and by lending or borrowing claims and marketable instruments, whether in Community or in non-Community currencies, as well as precious metals;
— conduct credit operations with credit institutions and other market participants, with lending being based on adequate collateral.
18.2. The ECB shall establish general principles for open market and credit operations carried out by itself or the national central banks, including for the announcement of conditions under which they stand ready to enter into such transactions.
It’s worth noting that while Article 18 gives the ECB fairly broad powers to buy and sell securities, it places a constraint on the purpose for which these market transactions can be conducted. In particular, these powers have been granted “in order to achieve the objectives of the ESCB,” which are specified in various documents, including the Maastricht Treaty.
The Maastricht Treaty
The powers granted the ESCB by Article 18 of the Statute are further constrained by Article 104 of the Maastricht Treaty, now article 123 of the Treaty for the Functioning of the European Union (TFEU). The first paragraph of Article 104 prohibits monetary financing of EMU Member States and deserves careful consideration.
Overdraft facilities or any other type of credit facility with the ECB or with the central banks of the Member States (hereinafter referred to as ‘national central banks’) in favour of Community institutions or bodies, central governments, regional, local or other public authorities, other bodies governed by public law, or public undertakings of Member States shall be prohibited, as shall the purchase directly from them by the ECB or national central banks of debt instruments.
It's important to note that the prohibition in this paragraph is of purchases that are made “directly” from EU sovereigns. The lack of an explicit prohibition against secondary market purchases has been seized upon by those advocating that the ECB act as a lender of last resort for Member States by purchasing significant quantities of sovereign debt in the secondary market. However, secondary market purchases for this purpose appear to be restricted by a regulation issued in 1993 by the Council of the European Union as part of the implementation process for the Maastricht Treaty.
Council Regulation (EC) No 3603/93 of 13 December 1993
In EC No 3603/93, the Council addressed the issue of secondary bond market purchases by clarifying the definition of the phrase, “other type of credit facility” in paragraph 1 of Article 104 of the Maastricht Treaty (Article 123 of the TFEU). The relevant article appears below with the key text highlighted in bold for easier reading.
1. For the purposes of Article 104 of the Treaty:
(a) 'overdraft facilities' means any provision of funds to the public sector resulting or likely to result in a debit balance;
(b) 'other type of credit facility' means:
(i) any claim against the public sector existing at 1 January 1994, except for fixed-maturity claims acquired before that date;
(ii) any financing of the public sector's obligations vis-à-vis third parties;
(iii) without prejudice to Article 104 (2) of the Treaty, any transaction with the public sector resulting or likely to result in a claim against that sector.
In its Convergence Report of May 2010, the ECB also addressed this issue. In a section titled, Prohibition on Monetary Financing, the ECB commented on Council Regulation (EC) No 3603/93, noting “the prohibition includes any financing of the public sector’s obligations vis-à-vis third parties.”
The effect of the Maastricht Treaty, the ESCB Statute, and the associated Council Regulation is to permit the ECB to purchase sovereign debt in the secondary market with the intent to “achieve the objectives of the ESCB” but to prohibit secondary market purchases with the intent to provide monetary financing of Member State budgets.
This interpretation appears to be shared by the ECB, as evidenced in various ECB opinions. For example, in a legal opinion dated 25-Mar-10 on independence, confidentiality and the prohibition of monetary financing (CON/2010/25), the ECB indicated, “The prohibition of monetary financing prohibits the direct purchase of public sector debt, but such purchases in the secondary market are allowed, in principle, as long as such secondary market purchases are not used to circumvent the objective of Article 123 of the Treaty.”
And to underscore the importance of these restrictions and its commitment to them, the ECB also wrote in that section, “The monetary financing prohibition is of essential importance to ensuring that the primary objective of monetary policy (namely to maintain price stability) is not impeded. Furthermore, central bank financing of the public sector lessens the pressure for fiscal discipline. Therefore the prohibition must be interpreted extensively in order to ensure its strict application...”
The Securities Market Programme
The ECB has repeatedly stressed the limited and specific purpose of the SMP. For example, in the ECB Decision to establish the SMP, it cited “...severe tensions in certain market segments which are hampering the monetary policy transmission mechanism and thereby the effective conduct of monetary policy oriented towards price stability in the medium term.”
With this in mind, the critical issue at the moment is whether the ECB believes significant purchases of Italian debt would be to enable the effective conduct of monetary policy or to provide monetary financing for a Member State. Reasonable people can and do differ on this issue, at times considerably. For example, Axel Weber, at one point the presumptive successor to President Trichet, and Jürgen Stark, the ECB Chief Economist, were so strongly opposed to the SMP in its current form that they resigned earlier in the year.
With President Trichet having just ended his tenure as ECB President, it’s useful to consider the views of the new President, Mario Draghi.
The views of President Draghi
At his inaugural press conference as ECB President on November 3, Mario Draghi was asked a pointed question by a journalist. “Are you prepared now to make a commitment that you will do whatever is necessary to keep the euro area in one piece, including – if necessary – becoming the lender of last resort to governments?”
Draghi’s response was instructive. “I have a question for you: what makes you think that the ECB becoming the lender of last resort for governments is what is needed to keep the euro area together? No, I do not think that this is really within the remit of the ECB. The remit of the ECB is maintaining price stability over the medium term.”
From this response, it appears Draghi is not inclined to support additional purchases of Italian debt for the purpose of providing monetary financing for Italy.
The Bottom Line
The clear legal intent at the establishment of the monetary union was to avoid monetary financing of Member State budgets, and President Draghi appears committed to upholding this principle.
It appears reasonable to expect that moderate purchases of Member State debt will continue for the specific purpose of facilitating the transmission mechanism for monetary policy. But calls for the ECB to contravene the enabling treaties, statutes, regulations, and decisions of the monetary union appear to be falling upon deaf ears. Regardless of any economic arguments to the contrary, the legal issues simply don’t appear consistent with the ECB assuming a lender of last resort function with respect to Member States. If the market refuses to provide additional financing for Italy at some point, it appears the Italians will have to look elsewhere for assistance in financing their budget.