First, the idea so far is to use the EFSF’s Co-Investment Funds (CIFs) for the bond purchases. However, the CIFs are reliant on private-sector funding to augment the EFSF. The only private sector institutions likely to participate in secondary market sovereign debt purchases are banks that have been heavily leaned on by their governments. This therefore only serves to tighten the sovereign/banking loop in the eurozone.
The second problem with using the EFSF/ESM to purchase sovereign debt in the secondary markets is that it will likely benefit the creditors more than the debtors. In this sense this proposal is very similar to a debt buyback scheme. After the EUR100bn bank bailout for Spain, the EFSF/ESM will have EUR400bn remaining for secondary market bond purchases. Investors are going to recognize that there is a big buyer in the market with a limited arsenal and may use the opportunity to sell and reduce their exposure to the periphery. However, EFSF/ESM bond purchases will almost certainly drive bond prices up. This will not only render the operation extremely expensive and inefficient, but it could incentivize banks to hold onto their peripheral sovereign debt; if bond prices are rising, then the value that banks can borrow against that collateral will improve. This would not hold true if there were a credible threat of imminent sovereign default (see Eduardo Levy-Yeyati‘s piece for an explanation), but the EFSF/ESM programme would be designed in theory specifically to reduce such a threat for Spain and Italy in particular.
If the idea of EFSF/ESM bond purchases in the secondary markets is among the items agreed over the next two days in Brussels, then there may be a brief market rally. However, this measure will serve as yet another delaying tactic, and does not address any of the underlying causes of this crisis. Investors will recognize this quickly, and any market rally inspired by EFSF/ESM bond purchases would in my view represent an opportunity to sell.