ECB Will Build a Bridge…But to Where?
August 2, 2012 1 Comment
All eyes are on the ECB governing council meeting on August 2nd to see exactly what Mario Draghi meant last week when he pledged that the ECB would preserve the euro. The way the markets have rallied off the back of this statement, it seems that investors think that the ECB is poised to intervene aggressively. Will they be disappointed? EZ policymakers have practically made an Olympic sport out of under-delivering throughout this crisis. Still, I think the ECB will succeed in sustaining the current market rally. The big question is whether EZ policymakers use the time lent to them by the ECB wisely, and on this I am highly skeptical.
ECB Will Buy Time
Both ECB President Mario Draghi and governing council member Christian Noyer have recently referred to the transmission mechanism of monetary policy being blocked. It is therefore unlikely that we’ll see a rate cut at tomorrow’s governing council meeting. More likely the ECB will try to unblock the transmission mechanism first.
One way to do this is to reactivate the Securities Markets Programme (SMP). There is a chance the ECB might restart the SMP immediately to reduce Spanish and Italian sovereign bond yields. The Bundesbank responded to Mr Draghi’s comments last week by immediately declaring it continues to oppose bond buying as it provides false incentives. Furthermore, the ECB was burned by Silvio Berlusconi last summer when he immediately went back on his promises of structural reforms following ECB intervention via the SMP.
Consequently, the ECB may announce that it will only reactivate the SMP if a country is subject to the conditionality required when a country has requested primary market bond purchases by the EFSF (and later the ESM). As Hugo Dixon points out, this kind of dual-pronged approach to bond buying—with the EFSF buying in the primary markets and the ECB buying in the secondary markets—would be much more powerful than the ECB’s SMP purchases have been in the past.
What Will Policymakers Do With the Time?
Having simultaneous primary and secondary bond purchases for Spain and Italy should manage to sustain the recent market rally, particularly given that trading volumes are very thin as many traders are off on their summer holidays. But for how long will the rally last?
The ECB has been insistent that it is not willing to monetize debt or offer quantitative easing unless EZ policymakers show they have agreed a clear, credible road map towards a full political, fiscal and banking union. It therefore seems unlikely the SMP will be unlimited in nature. EFSF and SMP bond purchases will buy some time, but the bigger question is what policymakers do with that time.
Ideally, Spain and Italy would use the extra time to implement painful structural reforms to open up their product and labour markets and regain competitiveness. The weaker EZ countries would also use the time to lay down a credible track record of hitting their fiscal targets. At that stage, the core countries would ideally be willing to move towards a full fiscal and banking union. In the first instance, this could come in the form of the ESM being allowed to use ECB financing to lend in an unlimited fashion to the peripheral EZ countries.
I’ve used the conditional tense a lot in that last paragraph, largely because I think all these things are unlikely. Spain and Italy are very unlikely to hit their fiscal targets going forward given their growth outlooks, austerity fatigue is likely to set in in both countries and Italy is facing an election early next year that could see its structural reform programme stall. EZ policymakers have taken the first step towards a banking union, vowing to install the ECB as a EZ-wide banking supervisor by January 1, 2013. There is still a long way to go before policymakers agree the other tenets of a banking union: a EZ-wide deposit guarantee scheme and a bank insolvency programme. And that’s to say nothing of a fiscal union, which is in any case off the table at least until after the German elections in September 2013. The ECB is aiming to build a bridge to closer integration, but in the absence of additional steps towards a political, fiscal and banking union, it may be building a bridge to nowhere.
For additional analysis on what to expect from the ECB’s governing council meeting tomorrow, see RGE’s “Time for the ECB to Put Up or Shut Up” and “Will Mario Draghi Put His Money Where His Mouth Is?“