ECB chairman Mario Draghi has promised to do ‘whatever it takes' to save the Euro. Do the markets believe him? John Greenwood, chief economist at Invesco Ltd, shares his views on saving the euro
Q: Do you think Draghi will be able to keep his promise to save the euro? Has he overplayed his hand?
A: In my view, Mr Draghi overplayed his hand. In London on July 26th he had promised to do "whatever it takes" to save the euro, but apparently he did not mean that he would deliver on August 2nd. There was no rate cut, no SMP (Securities Markets Programme)
re-activation and no introduction of a new LTRO. In fact it turned out that the Governing Council of the ECB has merely instructed three specialist committees of the ECB to design "the modalities over the coming weeks" for undertaking outright open market operations - by which he meant buying short-term government bonds and conducting other "non-standard measures".
Q: Will re-activating the ECB's bond-buying programme for Spain and Italy in tandem with the eurozone's rescue funds do the trick?
A: No. Market participants are looking to the ECB for either large-scale, open-ended purchases of government bonds of peripheral, crisis-affected economies (a kind of QE), or some assurance that yields on these instruments will not be allowed to rise above some specified level. Without these kinds of overwhelming guarantees, any programme of limited or incremental purchases is simply not going to prevent yields from rising further. The reason is that with Spain, Italy, Greece and Portugal already in recession, GDP is falling, and that means that even with no further increase in government debt, the government debt-to-GDP ratios will be rising. For investors, rising sovereign debt ratios are a highly negative signal.
Q: What other measures could Draghi use? Any you would recommend? Do you think he will cut interest rates (again)?
A: Draghi and the Governing Council decided not to cut interest rates any further in August. Following the changes made in July the ECB's main refinancing rate is now at 0.75% and the rate paid on deposits is now 0%. It is possible that the main refinancing rate could be cut to 0.5%, but with rates already so low any reduction is not likely to change the amount that banks are willing to borrow from the ECB very much.
This means that from here onwards the ECB is now going to have to focus on "non-standard" measures such as asset (bond) purchases, just like the Fed or the Bank of England. Hence the request today to the three specialist committees to design a bond-purchasing policy that is "within its mandate to maintain price stability over the medium term".
Q: Will he be able to find a way to get any measures past Germany? Could the Bundesbank derail the process?
A: The problem with these proposals is that Germany has already expressed its reservations. Following Mario Draghi's speech in London, the Bundesbank reiterated its opposition to bond purchases, and in a news conference at the beginning of August, Draghi conceded that Jens Weidmann, President of the Deutsche Bundesbank, had reservations about the policy. It therefore seems that the hurdles to implementing a QE programme in the Eurozone are still very high.
Q: Did Draghi paint himself into a corner? What would the ramifications be for the ECB should Draghi fail to keep his promise?
A: When Mario Draghi announced that the seniority issue would be taken care of in any bond purchase programme, the euro rallied sharply from $1.2265 to $1.24, but as soon as he clarified that the Governing Council had merely requested the specialist committees to design a policy over the next few weeks, the markets abruptly sold off again. In the words of one commentator, "the market went from risk-on to risk-off mode".
In fact it is worse than that. Draghi's press conference made clear that before the ECB would be willing to buy Spanish or Italian bonds, the country in question must formally request EFSF/ESM support. In other words, the ECB will not step into the bond markets until things have worsened to the point where the country has appealed for a Greek-style rescue. Investors looking at Spanish or Italian sovereign bonds will remember the Greek debt haircut.
In short the new programme promises to be a version of QE (assuming the Germans will agree), but it will only be activated after Spain or Italy fall deeper into crisis.