Politics & Policy - The ECB Solution is Flawed

Late last week, Mario Draghi, head of the European Central Bank set forth his proposal as it relates to sovereign debt purchases by the ECB. These “outright monetary transactions” (OMT) as he called them will be implemented in order to drive down the cost of capital for those European nations struggling to meet their budgetary needs.

The announcement by Draghi appeared to have a desirable outcome as global equities rallied quite aggressively and bond yields for both Spain and Italy fell to 5 month lows.

While the move appears to have bought some time, it certainly is no panacea and after further inspection, carries certain faults that would accelerate the crisis in Southern Europe. 

 

More on that later, for now, let’s reiterate what was done and how it will be put in to effect.

The ECB announced that it is willing to step in to the open market and purchase shorter-term sovereign debt to prevent excessive cost of capital for those European nations in a bit of trouble. The hope is to buy them time by keeping costs in line while fiscal reform in conceived and implemented on a country level.

There are certain items to this deal that should be brought to light.

 

First, the ECB has stated that in order to qualify for this bond buying strategy, stiff and strict conditions will need to be met and maintained. These conditions will most likely include new austerity measures and some fiscal discipline.

Second, the ECB went out on a limb to articulate their “unlimited” effort in purchasing these bonds.

Third, he stated that the ECB will not take a priority claim over the private sector in the case of a default or re-work. They have also lowered collateral requirements and will accept less than stellar collateral for these purchases.

Lastly, they claim that these purchases will be “sterilized”. Our translation is that whatever money is pumped into the system through these purchases will be equally offset by pulling money out of the euro-zone elsewhere. This is being done to address inflationary concerns that typically follow aggressive monetary expansion.

 

Problems with the Plan

We see inherent flaws in this plan that give us pause about buying into the stock market rally. While we are never one to “fight the tape” or bet against a trend, it is our opinion that the market may have overreacted to this initial announcement.

To address the first point of conditionality, the ECB has made it clear that any nation seeking “help” with their cost of capital needs to formally request it and then adhere to a strict austerity plan set forth. This is a problem in and of itself in that there is no way any European nation is going to seek this help unless their economy is starting to crumble around them and there is absolutely no other options. Reading the Financial Times on 9/7/12, there was an article that stated “Spain will not be forced into requesting a rescue until the attached conditions become crystal clear…setting the stage for a prolonged stand-off between the government of Mariano Rajoy and European authorities.”

Taken from the same article, the ECB reiterated, “any assistance from the central bank to reduce Spanish borrowing costs would come with “strict and effective” conditionality, the Rajoy government remained steadfast that a request would be made only if, and when, it was ready.”

One needs to consider that Italian sentiment is even firmer given their size and importance to the euro-zone. Thus the stand-off continues as southern European nations refuse to surrender fiscal sovereignty and political leaders avoid electoral defeat in return for help from the ECB. Only under the most extreme circumstances will these nations ask for help, and given the moral hazard infused into the bond market driving yields lower, why would they ask for help now?

Bottom Line: For this plan to be accepted, we need a major fiscal disaster to arise in Europe. This is hardly a reason to bid up stocks in our opinion. We expect tough negotiations later this month will destabilize the stock and bond markets.

In regards to the second item of unlimited purchases, this is very dangerous language for the ECB because it commits them to potentially trillions of euros in bond purchases that would ultimately wreak havoc on their balance sheet OR go back on this unlimited promise and wreak havoc on their credibility. Either outcome will have an undesirable effect on the global markets and may even threaten the euro experiment.

Additionally, let’s say we are a year into this new bond buying effort and one European nation determines the austerity rules are too difficult to achieve and indicates to the ECB that they need to restructure their initial conditions agreement. What will the ECB do at that point? Pull the plug on the bond buying initiative mid-way through and ensure a sovereign debt default that will ruin their balance sheet and destroy the euro? 

 

Bottom Line: Once the ECB starts to purchase bonds in the open market, they will become an “enabler” and provide a false sense of security to market participants and European leaders. This is the danger of moral hazard. 

Another question as it relates to the sterilization of new bond purchases remains will this action hurt a European economy that is already in recession. The debate continues as to the effectiveness of government spending and economic growth. In smaller European nations such as Ireland, Greece and Portugal, many economist blame superfluous austerity measures as the reason these nations have fallen deeper into recession. Thus the question needs to be asked, if the ECB funds budgetary shortfalls for a specific nation but commands intrusive anti-growth austerity measures while simultaneously sterilizing that money by removing it from another part of the European economy will this action push the euro-zone further into recession?

Bottom Line: Market participants were quite pleased with the decision stemming from the ECB, but on further analysis this plan may turn out to be a pig in a poke.

This week in Europe

We will have continued data flow out of Europe this week. On Thursday, Germany’s constitutional court will be ruling on the legality of a permanent financial rescue fund. While recent legal polls show a low probability of an unfavorable ruling, should the court rule against the legality of the rescue fund, it will be chaos in the financial markets. Most likely it will be a favorable ruling with caveats, probably related to the conditionality outlined by Draghi last week.

Also on Thursday the European commission will continue to provide insight into a euro-zone banking union. This will undoubtedly be a herculean task given the 6000 banks that make up the European banking system (although 95% of banking assets are held at 200 banks).

- Joseph S. Kalinowski, CFA

 

 

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