Last Thursday’s ECB meeting was probably the most closely watched Central Bank event.

I’m going to dwell on Draghi’s remarks as they were highly important and, in my opinion, particularly bullish.

The initial reaction was that Mr Draghi did not meet a number of expectations (given his very strong statements a week or so ago. Interestingly, in the Q&A session, he stated that his previous comments were approved by the ECB’s Governing Council ie allaying the charge that he was shooting from the hip). However, the initial reaction to Mr Draghi’s statement was, in my opinion, a mistake/misunderstanding. I analyse his comments in detail below.

a) inflation “should decline further in the course of 2012 and be below 2% again in 2013″ (he subsequently suggested that inflation would be “around 2.0% by the end of the year”). Indeed “it is decreasing more quickly than expected” and that “economic growth in the euro area remains weak”, suggesting at least one more interest rate cut – very likely, sooner rather than later, as previously, he has acted on forecasts rather than on the actual numbers – sensible. Interestingly, Mr Draghi stated that increase in food prices were considered “one off shocks”, a divergence from Trichet’s time, when the ECB did not consider the “one off” nature of price increases as they impacted inflation – again, sensible. The introduction of negative deposit rates were “uncharted waters” for the ECB, which suggests that it remains a possibility, though I guess unlikely in the very short term;

b) the ECB “may” reintroduce the SMP programme “of a size adequate to reach its objectives”. In the Q&A session he stated that there will be “full transparency….about the amounts”. I’m not sure how the ECB will know, in advance, as to the amount of bond purchases that will be needed to reach its target (indeed, Draghi admitted that in the Q&A session), unless, subsequently, they say that they will buy as many bonds as is needed to reduce rates to a certain level ie introduce a targeted maximum yield policy. He emphasized that the ECB’s Governing Council “endorses the remarks that I made in London about the size of these measures, which need to be adequate to reach their objective” ie it will be big enough – highly important and particularly bullish;

c) In a clear break with tradition and very pointedly (he named Mr Weidmann – who is unlikely to be on Draghi’s Christmas card list from now on !!). Draghi stated that “it’s known that Mr Weidmann and the Bundesbank – although we are here in a personal capacity and we should never forget that – have their reservations about programmes that envisage buying bonds, so the idea is now we have given guidance”. He added, “Basically, the Monetary Policy Committee (“MPC”) and the Market Operations Committee (“MOP”) will take the final decision by vote” ie whatever you and the Bundesbank may think Mr Weidmann, the ECB will be buying peripheral debt (short term bonds and subject to adherence to predetermined conditions by the relevant countries – see below).

Specifically, Mr Draghi emphasized that, with the exception of one member (Mr Weidmann), the “guidance” to be provided to the MPC and the MOP was “unanimously” agreed by the ECB’s Governing Council (comprising 23 members), which clearly means that Mr Weidmann was unable to persuade representatives from Germany’s traditional allies, including Holland and Finland, or, indeed, his German colleague Mr Asmussen otherwise – once again supporting the prospect that the ECB will be buying short term bonds. This is particularly important and suggests, quite strongly, that Draghi will get his way;

d) He added that the purchases by the ECB would be “focused on the shorter part of the yield curve”, where Central Bank action can make a difference ie the ECB would buy peripheral debt of up to 2 years in the secondary market. He emphasized that this policy was “one that falls squarely within our mandate” and “does not violate the prohibition of monetary financing in any way”. Difficult to argue against in my opinion and a clear snub to Mr Weidmann, who continues to oppose any bond buying programme by the ECB. He emphasized, once again, that the effectiveness of monetary policy transmission policy of Central Banks was paramount and within the ECB’s mandate. Once again, difficult for Weidmann to argue against coherently and/or with much conviction – hugely important and positive;

e) However, the ECB would only participate in a bond buying programme of peripheral debt, if those countries which needed assistance, first requested assistance from the EFSF/ESM and, importantly, only if the relevant countries continued to adhere to the “strict and effective conditionality in line with established guidelines” imposed by the EFSF/ESM (which I suspect, will include labour and structural reforms). He added that to seek assistance from the EFSF/ESM “is a necessary condition, but not a sufficient one, because monetary policy is independent” and that the ECB will announce, “over coming weeks, the appropriate modalities for such policy measures”. This will be music to the years of Mrs Merkel and the German authorities, who have been trying to force the peripheral countries to adhere to pre agreed targets, especially in terms of their budget deficits and, in addition, to agree to structural, including labour, reforms to improve competitiveness. Basically, Mrs Merkel will give Draghi a huge kiss and Draghi’s relationship with Mrs Merkel (which was already good) will have improved immeasurably – highly important;

f) In response to a question, he stated that it was up to governments to issue the ESM with a banking licence and not the ECB’s task, though it was up to the ECB to decide whether the ESM “can actually be a suitable counterparty”. He added that the ECB had obtained legal advice which states that “the current design of the ESM does not allow it to be recognised as a suitable counterparty” for the ECB. The important words here are “the current design” and is clearly a deliberate fudge (to avoid possible problems for Germany ahead of the Constitutional Court decision on the 12th September, etc) in my opinion, as the ESM can be re designated as a credit institution, as is the European Investment bank (EIB”). As a credit institution, the EIB (and therefore the ESM, in due course) is a counterparty to the ECB and, furthermore, does lend to EZ governments – indeed, it is it’s task. Hey presto, the ESM will have sufficient funds available to intervene effectively in the markets.

However, today, the German’s have repeated their opposition to granting the ESM a banking licence – indeed, the Foreign Minister stated it would not be in accordance with Germany’s Constitution. This game will continue, but at the end of the day, the ESM has to be leveraged (it may be allowed to issue bonds to increase its resources as an alternative, but, in reality, it’s just a presentational issue), as the current size is simply insufficient for its intended task and no other EZ country wants to increase its contribution. Essentially, the firepower of the ESM has to be increased.

I remain of the view that the ESM will be granted a banking licence and, in addition, that it will be designated as a suitable counter party by the ECB, as the resources otherwise available to the ESM are simply insufficient (materially) for its task, even assuming that all of the relevant countries continue to contribute to it, which clearly will not be the case. However, the alternative (to deal with German concerns/opposition) is for the ESM to issue bonds, which can be used as collateral to obtain financing from the ECB ie will have demand. With fewer countries contributing to the ESM, the burden on the rest of the EZ countries will become unsustainable, otherwise. One way or the other, the ESM will obtain more than adequate cheap financing from the ECB – once again bullish;

g) Draghi, in a somewhat convoluted way, stated that “it’s too early to say whether (bond purchases by the ECB) are going to be sterilised or not sterilised”. Given the Bundesbank’s opposition and the impending, inter alia, German Constitutional Court decision together with the Dutch general elections in September for example, unsterilised QE is a pretty delicate issue for the ECB (and indeed for the German’s) to address at the moment, but I believe that the ECB will be forced into unsterilised bond purchases (ie outright QE), when the political conditions are right (even though the ECB is supposed to disregard political considerations), as is the case in the US and the UK, for example. Yet another bullish point;

h) Mr Draghi, stated that the ECB was considering other options, with reference specifically (though not exclusively) to LTRO’s ie another LTRO programme (possibly) and/or extending the maturity of the existing 2 LTRO programmes (more likely) and/or loosening the collateral requirements (a near certainty) – basically, watch this space, though, once again, positive;

i) “the concerns of private investors about seniority will be addressed” ie it’s likely that the ECB will not place itself ahead of other creditors in the event of a default, though he refused to provide details – this is a very important issue for existing and prospective investors and, if the ECB agrees that it will rank pari passu to other bondholders, is very bullish, once again;

j) “structural reforms”, including labour reforms and improving competitiveness were essential for any country that wanted the ECB to buy it’s short term debt in the secondary markets. It is clear that Europe needs major structural, including labour reforms, to improve competitiveness, as Mrs Merkel and the German’s have been urging – once again music to Mrs Merkel’s ears;

Outlook

The details, particularly in the Q&A session were far, far more positive than initially viewed by the press, analysts and markets, hence their sharp rise of markets on Friday, with a follow through this morning. Essentially, Mr Draghi is pushing Mrs Merkel/the Germans agenda, namely forcing the relevant countries in the EZ to address their fiscal position, especially their budget deficits and to implement structural, including labour reforms to improve competitiveness. If they do, their borrowing costs will decline materially. If not, their borrowing costs will rise materially and, indeed, they may (indeed will) be shut out of markets altogether, an issue which will certainly exercise their minds. Furthermore, I would argue that he has further isolated Mr Weidmann and the Bundesbank.

Draghi has focused the ECB’s rationale for considering buying short term debt instruments as “it falls squarely within the range of classical monetary policy instruments”, by emphasizing the need to ensure that the transmission of monetary policy of Central Banks is effective, which is hard to argue against, I believe, even by the Bundesbank/Mr Weidmann.

Unsterilised bond purchases or QE (which I continue to believe is where the ECB is heading) will be a whole different ball game, given the German hatred/fear of money printing, but he did get the Governing Council, including the representatives from Holland and Finland and the other German (Mr Asmussen) on the Governing Council to support the view that it was being “studied” ie read it is likely.

Few German’s have expressed support for Draghi’s plan to date – indeed, most of the comments remain opposed. However, does Germany really have any other alternative, especially if it wants to see the Euro survive – I think not. Privately, I would not be surprised if Mrs Merkel, in particular, is supportive, though does not say so publicly, for domestic political reasons. The alternative – well a break up of the Euro Zone will cost Germany dearly, even if you ignore the widely held German view that they want the EZ/Euro to survive, though quite possibly without Greece.

In addition, he has, quite rightly, forced countries such as Spain (who have been in denial) and, most likely Italy, to formally (jointly?) seek assistance from the EFSF/ESM (which will be the buyers of medium/longer term debt) in the first instance ie be subject to the conditionality, imposed by the EFSF/ESM, which will have to be strict enough to convince the ECB. There are already indications that both countries will do so – in any event, they have no alternative.

I remain of the view that the ECB will accept the ESM as a valid counterparty ie the ECB will provide the leverage that the ESM so desperately needs ie the size of funding available for purchases of peripheral debt will be sufficient. The alternative (to overcome German concerns) is to allow the ESM to issue bonds to leverage up its resources, which is clearly necessary. This really is the big bazooka that is very much needed.

It’s the classic hammer and velvet glove approach. The risks, well Draghi has to deliver on the above. In addition, politically, the measures that need to be enacted by a country to adhere to the conditionality (imposed by the EFSF/ESM and agreed by the ECB) may well be unsaleable to countries public. Then there is the decision by the German constitutional Court to be considered – likely supportive, though they may seek some further conditionality. However, I would argue that the measures announced by Draghi will help to support a favourable decision by the German Constitutional Court. Most importantly, these measures provide political cover for those countries that are, in effect, providing the financing. In addition, they force EZ politicians to enact the necessary measures to help to ease the crisis in the region, a key issue for Draghi and the ECB.

France will remain a major risk – more on that at a later date. The impact of the above measures will force France to enact major changes, which I suspect, will prove very difficult for President Hollande. I continue to remain extremely wary of France. 10 year French bonds are yielding just 2.11% at present, which seems pretty rich to me.

The timing to implement the above will take time – certainly not in the next few weeks.

In summary, the ECB has previously dealt with the liquidity risks of European banks (the LTRO programme), though I accept that a large number of banks need to address material solvency issues ie they need to raise a material amount of capital. However, importantly, the LTRO programme has provided further time. In addition, if the ECB takes the actions it indicated last Thursday, short term sovereign borrowing rates of the peripheral EZ countries, will decline sharply – indeed they have already and are likely to decline even further – the longer term debt, as well, though by not as much, resulting in a wider 2 to 10 year spread. This may force the peripherals to seek finance through the issue of shorter term debt – not at all ideal, I must admit.

A reduction of medium to longer term rates of peripheral EZ countries will be the responsibility of the EFSF and the ESM – ie they will be buyers of longer term bonds in size, given the leverage which is likely to be provided by the ECB. Interestingly, yields on longer term German debt (the 10 year is at 1.37% at present), look difficult to sustain at these low levels, especially in the medium to longer term, in my opinion. Shorter debt German debt is effectively zero to negative, something which will result in a credit bubble in Germany, unless addressed. Draghi’s proposal will help.

If and when these policies are implemented, the contagion risks from a Grexit will have reduced materially. I continue to believe that Greece will exit the Euro (over 90% probability) quite possibly this year, unless the country miraculously adheres to its bail out conditions, which is highly unlikely. Interestingly, reports today suggest that Greece has promised to do more and the Troika has been positive. Don’t hold your breadth and they had better deliver this time around, as patience has run out. The Troika is to revisit Greece in September ie the EZ don’t want any problems at this stage and not before they secure agreement and, in addition, put the above plan in place – may take longer than September though.

The above measures if implemented (likely), as proposed by Draghi, are bullish. Yes, there are risks, but………..

Indeed, I could argue that Draghi’s plan is even more important that his previous LTRO programme on behalf of European banks.

Finally, the Euro has risen following a more detailed analysis of Draghi’s comments. Whilst it may have more to go, I remain sceptical/bearish on the Euro, certainly other than in the short term.

Kiron Sarkar

6th August 2012

Category: Think Tank

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