Following Mario Draghi’s remarks last week in London, wherein he promised that the ECB stood ready to do ‘whatever it takes’ to save the Euro, as long as it was ‘within its mandate’, the markets were flooded with a wave of optimism. This optimism took on frenzied proportions as the head of the Austrian central bank, one of 23 members of the ECB’s governing council, evidenced support for the idea of the ESM getting a banking license. Much of this optimism has vanished in the face of the reality that confronted markets at the ECB’s press conference today. That is not to say that there has been no progress, only that what has been announced is not a game-changer.
At the time of Mr Draghi’s remarks, we at Re-Define had clearly warned people not to read too much into them. Our scepticism derived from a number of points – First, there was little new in the substance of Draghi’s remarks. The reference to the transmission of monetary policy being broken was not new, nor was a commitment to do whatever it takes though it was expressed more forcefully this time round. Second, when ECB executive council members speak, they are not articulating set ECB policy. The ECB is not the tightly-run ship that many outsiders assume it is. Each of the executive board members articulates things that are not ECB policy. The clearest example of this was the banking union discussion that came as a surprise to many within the ECB. Third, no matter how serious Mr Draghi was or what he had in mind, he is operating under some serious political and technical constraints as we have highlighted in our must read note “Spiking Skywards? Tackling Rising Yields in the Eurozone”
As it turns out, we were right to be sceptical. The ESM banking license, we had warned, remained a still-born idea, no matter how much sense it made. For that idea to work, it would require a continuing unanimous support from all 17 of the Euro area governments, something the idea clearly does not enjoy. It would also require a decision by the ECB to make the ESM an eligible counterparty, something the ECB itself has opposed for several months. We said this was not in the works and Mr Draghi confirmed our suspicions. So much for the bazooka!
The other option that could have been a game-changer would have been an announcement of yield targeting in the sovereign bond market as Re-Define has suggested since 2011, or the announcement of an open-ended commitment to secondary market purchases of sovereign bonds in the market backed by a strong support from the governing council and an explicit renunciation of seniority as we suggested in a recent note. Here the ECB’s meeting also disappointed but kept some hopes alive.
A glimmer of hope, but no more
In particular, the ECB governing council has issued guidance to its committees so it “may undertake outright open market operations of a size adequate to reach its objectives.” When quizzed further, Mr Draghi said that any purchases would only happen once Italy and Spain had agreed to an EFSF/ESM program with appropriate conditionality, something that both Italy and Spain remain loath to do. In response to a question, he also said that any ECB bond purchases would focus on the short-end of the curve and also that the ECB would address the concerns of private investors about seniority. All of this signals that the ECB is indeed planning to revive its Securities Markets Program (SMP) that has been in suspended animation since March, but with important changes.
At the time the SMP was introduced, there was no explicit seniority of the ECB’s claims but after the ECB claimed seniority on its holdings of Greek government bonds, that changed. Now, in order for the new SMP to be effective, the ECB will have to explicitly forswear seniority or its interventions could backfire. Mr Draghi’s specific reference to the short-end of the curve means that it is likely that the ECB will try and implicitly cap yields on bills and short-term bonds with maturities between 3 months and 1 year or possibly even two years. The ECB would find it easier to forswear seniority as long as its rising exposure was limited in time.
All of this means that both Spain and Italy would now be pressured into signing expansive Memorandums of Understanding with the EFSF and when it does come into being, the ESM, the Euro area’s two crisis management facilities. At this point, the EFSF may intervene in the primary or secondary bond market to relieve pressure on Spanish and Italian yields. Based on what the ECB has said today, it will not target long-term yields. That would be left to the EFSF and the ESM. But it has signalled a willingness to intervene in the short-term market to stop the yield curve from inverting (when ST yields exceed LT yields) or becoming too flat.
Given the limited size of the EFSF and the ESM and the ECB’s previously abandoned SMP, the burden of proof will lie with EU policy makers. There will be a lot of justified scepticism amongst investors about how deep the commitment to these policies runs and when the support for Spain and Italy may be abandoned. In order for this set of policies to have any chance of success it will need to 1) clearly communicate that both the ECB and the ESM have forsworn seniority on their new purchases of sovereign bonds and bills and 2) that the commitment to keep yields down is an open-ended one that embodies the principle of ‘doing whatever it takes.’. The announcement of particular yield targets or spread targets would be ideal but it is highly unlikely that this would ever be adopted.
Any communication which signals that 1) the support for an ECB intervention or EFSF/ESM intervention is lukewarm 2) that the size of the interventions would be limited 3) that the issue of seniority may come back retrospectively 4) that Italy or Spain may need to restructure their debts or 5) that the Euro may break-up would undermine the effectiveness of the interventions hugely. The worst case scenario would be if EFSF/ESM and ECB bond purchases are simply used to fund the flight of existing investors from Italian and Spanish sovereign bond markets.
But this set of interventions does not constitute a game-changer. With a banking licence for the ESM ruled out, the only real ‘bazooka’ option that has not been explicitly ruled out is something Re-Define suggested last year as a compromise. We discussed it briefly in our most recent note again and here is the excerpt
“The ESM could indemnify the ECB against any credit losses on its purchases of sovereign bonds. This could then free up the ECB’s hands to enact a much larger SMP. Economically, this is similar to the ESM bank model as the credit risk is taken on by the ESM and the funding comes from the ECB. However, unlike the ESM bank idea, which has explicitly been ruled out by key political actors not least Draghi himself, this idea has not been vetoed, yet. One could see how this may politically be more attractive than some of the other ideas that have been discussed but yet be economically workable. The ECB is very clear that they will not ask for such an indemnity but if the ESM were to offer one…”
All of this means that the ECB has indeed provided a glimmer of hope, but little more. The Eurocrisis continues to get worse at an alarming pace as we have highlighted in our pieces on the dangerous divergence dynamics at work in the Eurozone “The Eurozone Dumbbell trap” and on the morbid developments in the Spanish Economy “The Spanish Donkey” and on how Italy is doomed unless it gets support from its Eurozone partners and the ECB “The Italian Conundrum”. The promise of ECB measures announced today merely begins to address some of the symptoms of the serious economic and political dynamics at work in the EU so will only buy EU policy makers some time. Exactly how much, is hard to tell.
Sony Kapoor
Managing Director