The ECB's OMTs: A tale of governments, investors, and the central bank

• This paper provides a theoretical framework to help analyse the programme for Outright Monetary Transactions (OMTs).
• Uncertainty about whether dispersed creditors will roll over their debt creates solvent but illiquid sovereigns.
• The short-term effects of adjustment policies create tensions between making reforms and maintaining access to markets.
• Optimal intervention may imply financial assistance of a size that is not available for the European Stability Mechanism.
• The ECB might provide funds so as to galvanize creditors, and thus overcome the short-term effects of adjustment policies.

This paper analyses official financial assistance via ESM programmes, with and without the ECB's OMTs. As long as macroeconomic imbalances are small, ESM stand-alone programmes galvanize creditors into rolling over their loans, alleviate the liquidity crisis and help the country to implement adjustment policies. Yet the impact of fiscal consolidation and structural reforms is likely to be recessionary in the short run, since these reforms take a long time to pay off. Recessionary effects raise strategic uncertainty in the roll-over decisions of creditors, thus reducing the effectiveness of ESM liquidity assistance. With large imbalances, liquidity problems can only be overcome with credible and sizable official assistance. Adding OMTs to an ESM programme mitigates the policy dilemma, but does not fully restore investor confidence when macroeconomic imbalances are too large.