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The markets were disappointed when ECB president Mario Draghi announced that ECB bond purchases to bring down peripheral government bond yields would be strictly conditional on governments moving first to buy bonds through existing operational means, and indicated no broad based funding intiative. We recommend caution, particularly after seeing the diverse reaction from financial markets to the councils decisions.
Now that the dust has settled somewhat, we believe that the “open-market operations” are appropriate and should allay the concerns of Germanys central bank regarding the ECB overstepping its mandate.
Admittedly, the latest bank loan figures are not very encouraging. Even last months decision not to pay interest on money “parked” by monetary and financial institutions (MFI) in the deposit facility, does not appear to have been effective. In fact, the MFI have channelled funds out of this and into the “current account”(another ECB facility where minimum reserves are usually held), rather than lending money to the real economy. However, we believe that, over time, a combination of all these measures should start to bear fruit. We remain convinced that early signs of an economic recovery may appear at some stage next year, as the global economy expands beyond the EMU.
The concerns of policy makers in the US, and even in China, seem to suggest that the EMU areas malaise may be contagious. However, we still believe that growth in non-EMU economies can be supported by domestic demand and offset the negative contribution of lower exports to the eurozone. Therefore, our base scenario is that, more optimistically, a moderately expanding global economy may help the EMU to overcome its recession (albeit at different times across the region).
How Can the New ECB Initiative Support Government Finances?
Some investors may have been disappointed at the lack of a broad-based bond purchase plan such as the quantitative easing carried out by the U.S. Federal Reserve. We should make it clear that the ECBs main concerns and its open-market operations are not aimed at providing a “shield” against speculators. In fact, the “institutional” buyer of government debt is the rescue fund (the EFSF or, looking forward, the ESM), which would buy government debt when issued, thereby providing direct financing to any government requiring it.
This “conditional QE” should not be seen as a “light QE” (bound by the ECBs narrow mandate). Unlike the Federal Reserves “indiscriminate” QE, this one was intended for specific countries government finances and may also have the power to impose economic reforms. It is increasingly likely that the first test case may be Spain, which could become the fourth country rescued since the crisis began and could be subject to some sort of supervision, just like the “small three”. In this respect, the political debate may continue, as this “handover” would overwrite EMU treaty rules safeguarding the fiscal sovereignty of national governments.
Politics Still A Key Variable
Politics have been a factor throughout the crisis and we believe this will continue to be the case. Most investors could well be paying attention to the German governments more flexible approach, as evidence mounts that its economy is by no means immune to weakness in the global economic cycle, which could be aggravated by the EMU crisis (second-quarter GDP data was worse than expected).
However, Germanys firmness depends not only on its government, but also on other top institutions. Its Parliament has also been critical towards unconditional EU help to EMU countries which it may consider to be fiscally “profligate.” The German Supreme Court must also make a landmark decision regarding the legality of Septembers rescue fund. Based on past rulings, we believe that the judges are unlikely to declare the ESM, or any other rescue facility “against the Constitution”, but may put some constraints on any kind of loosely enforced fiscal union. This may lead to renewed risk aversion in financial markets.
Does It All Depend on German politics?
We do not think so. Indeed, Germany could be perceived by a majority of EU partners as placing too much emphasis on fiscal tightening, rather than on structural reforms, which in our view would more effectively enhance the long-term growth potential. In fact, it was structural reforms (notably in the labor market) that turned the former “sick man of Europe” into an economic powerhouse.
For its part. the EMUs “weaker side” should continue to pursue a path of fiscal austerity and economic reform. Due to their size, Spain and Italy inevitably attract the attention of investors; we believe that financial markets may be too sceptical regarding the commitment of these countries.
We fully agree with the view that Spain could have dealt more effectively with its banking crisis; the schedule of mergers and acquisitions involving struggling banks did not work, making the EU bailout necessary. In the meantime, the recession is getting worse and the prospect of a full sovereign bailout is gaining consensus. However, we think that if Spain asked for it, the plan would be less binding than those already agreed for the “small three,” and would take into account the progress already made; including progress on the key aspect of labour market reforms (as acknowledged by the IMF).
Where Does Italy Stand?
We agree with the Italian governments view that, based on current government figures, there is no need for a bailout. However, we also believe that investors would welcome a “memorandum of understanding” with the EU in order to “reinforce” the Italian governments program of austerity and reforms, making it near-impossible for the winner of the upcoming election to derail it. This commitment is necessary to convince financial markets and prevent further turbulence. An appropriate financial package for Spain, and a memorandum of understanding for Italy, may mark the beginning of the path towards an enforced fiscal union, a development which we would consider to be positive. Admittedly, this process involves some sort of fiscal supervision and is likely to meet political objection. As the debate goes on, the ECB is set to remain the interim manager of the crisis, with all the tools it has at its disposal.
Our preference for growth-sensitive assets is based on the ECBs commitment to “do whatever it takes to save the euro” and the structural reforms which have already been implemented in peripheral countries. When Mario Draghi says “we will succeed”, we do not think his intention is to challenge the speculators. Rather, he is eager to remind financial market players that holding full monetary sovereignty is no small thing; all the more so when other leading central banks look ready to support the global economy.
However, it is up to individual governments to provide lasting solutions to the crisis and, until that happens; peripheral bond markets may be less attractive. The case for these “risky” assets can be made based on how expensive safe-haven bonds are; in spite of yields which have turned negative, not only when adjusted for inflation, but also under normal circumstances.