Mario’s Magic

Mario Draghi, the ECB President, can look back over his first twelve months in office with a great deal of satisfaction with what he has managed to achieve.  What he has done has been necessary, but it is not sufficient to maintain the integrity, and indeed the existence of the Euro.

Mr Draghi took over from Jean-Claude Trichet with the peripheral Eurozone bond markets in crisis.  At his first meeting of the ECB last November, he reversed the ill-timed interest rate increase made by his predecessor in July.  At his second meeting, he cut interest rates again and announced a Long Term Repurchase Operation (LTRO), which allowed any Eurozone bank to borrow as much money as it wished (subject to collateral rules) at a rate of 1% for 3 years.  In February, he announced a second LTRO.  For banks in Italy and Spain in particular, this was a lifeline as the money enabled them to buy into bonds issued by their governments which were then yielding much more than 1%, and so locking in a profit stream.  These two LTROs injected over one trillion euros of new liquidity into the banking system and eased the escalating liquidity crisis in the Spanish and Italian banking systems.  Though providing liquidity to markets in times of great stress is part of the job description of any Central Banker, Draghi, was seen to be very bold by opting for 3 year LTROs, much longer than anything else that had been previously done by the ECB and in unlimited size, which restored confidence to the system.

Unfortunately, the Eurozone’s problems were much worse than a banking liquidity crisis.  As 2012 progressed, it became clear that the Spanish banking system had a major issue of solvency.  In July, the Eurozone countries appeared to agree that the new bail-out mechanism, the ESM, would be able to lend directly to the Spanish banks, without the funds becoming a liability of the Spanish government and thus increasing the sovereign debt.  This was conditional on obtaining agreement to the setting up of a European Banking Union.  Within a few weeks however, Germany, Finland and Holland reneged on this agreement and Spanish bond yields rose as fears of a Spanish bailout and debt restructuring returned.

At a speech in London, just before the Olympics, Mr. Draghi made a dramatic comment: – “Within our mandate, the ECB is ready to do whatever it takes to preserve the Euro.  And believe me, it will be enough”.  In placing the preservation of the Euro as its highest priority, it effectively downgraded the importance of its previous prime priority, the control of inflation – the only acceptable target for German Central Bankers.  He quickly gained the support of all the political leaders and all the other ECB members apart from the Head of the Bundesbank, Jens Weidmann.

Draghi’s plan was that once a country had requested a bailout from its Eurozone partners, which had been approved by the other member states (unanimously, but with conditions), then the ECB would be prepared to purchase unlimited amounts of that country’s bonds to ensure that the interest rates in that economy would be aligned with what the ECB regarded as reasonable.  To Draghi, this would ensure that the ECB’s policy on interest rates was not sabotaged by the markets pricing in a Euro-exit risk premium that should not exist.  For Mrs Merkel and other Northern European leaders, the power to decide on a bailout still remained with them, but the ECB was doing the hard work of putting up the money.  Draghi’s manoeuvrings had isolated the Bundesbank, which was the only dissenting voice within the ECB.

Over the last twelve months, Draghi’s boldness and creativity have kept the Eurozone with a functioning monetary system.  The financial markets have understood and applauded his moves, sharply bringing down the cost of borrowing for the peripheral governments.  For his actions to continue to be successful in keeping the Euro together, however, he needs the politicians to make some difficult decisions.  The Northern European creditors must be prepared to (i) take losses on their Greek bailout loans, (ii) lend Greece more money to get it back on its feet, and (iii) when Spain and possibly other countries come to request bailouts, then the conditionality they impose needs to be politically bearable within the debtor countries.  In turn, the Southern European debtors must be prepared to adopt structural reforms and spending cuts that are painful but necessary for their countries to live within their means.  German and Italian elections next year will bring confusing political rhetoric, but it will be their politicians’ actions rather than their words that will determine whether Mr Draghi will go down in history as the man who saved the Euro.


Eurozone poker – Monti calls Merkel’s bluff

At last week’s EU summit, Mr Monti refused to agree to anything until Germany made a key concession. He wanted the bailout monies for the Spanish banking system not to be structured as debt of the Spanish government.  In the end, Mrs Merkel gave in although this will not occur until a European banking supervisor has been established for the Eurozone banking system.

This concession is hugely significant in terms of a principle to which Germany has long held fast, in that it appears to contravene the Maastricht “no bailout” clause – recapitalising a banking system requires equity capital not debt capital. Europe will now use its emergency funds to inject new equity into the Spanish banks. This cannot be portrayed as emergency lending to fellow European sovereigns as all previous rescue loans have been. Providing equity capital to bankrupt institutions is inherently a far riskier proposition than lending to a sovereign state, and so it is impossible now to maintain the facade that German taxpayer money is not being put at risk.

As time moves on, Germany and others will find themselves facing the classic sunk cost problem – if more money is required to keep these banks afloat, then the capital provider feels under greater pressure to do so, to avoid writing off the previous investment. This is the first step down a slippery slope – the second step will come when a more rigorous and independent audit reveals that Spain’s banks require far more than the E62bn currently mooted in order to recapitalise. Next Ireland and Greece have already made clear that they want to get (retroactively) the same terms as Spain for their banking recapitalisations, and finally the Italian and French banks will be looking enviously at the cheap equity capital Spanish banks have now secured.

Mrs. Merkel does have a cooling-off period though. The principle has been conceded subject to agreement within 6 months of a new European banking supervisor. This leaves many vital areas of disagreement over details and, probably, ratification in all 27 EU states. Key areas still to be resolved are which banks fall under the direct supervision of the European regulator, what will  be the role of the current national banking supervisors, and most importantly of all, who has responsibility for deposit guarantee insurance. It would seem obvious that any deposit guarantee scheme would have to fall under the auspices of the European banking regulator, but it is not clear where the money would come from. Most politicians do not wish to provide their own taxpayers money to bail out bank depositors in other countries – instead they are hoping it will be funded by the banking system itself via a Financial Transactions Tax. In the long term this may be a viable solution, but in the short term the fund would be empty for several years and the potential demands on it huge given the fragility of European banks.

One further factor which should not be ignored is that in September 2013, Mrs Merkel faces re-election. Should she concede too much to the rest of Europe over the next 12 months, she faces huge domestic political problems. There is talk that a possible way out of her dilemmas is for Germany to hold a referendum on whether it should continue to support its European partners to enable them to remain in the single currency. German public opinion is currently split on this and such a referendum would leave European financial markets paralysed until the matter was resolved.

The markets have rallied strongly on the abandonment of the Maastricht “no-bailout” clause, and the first move towards more integrated European institutions. However history suggests that there are many more late-night summits and games of brinkmanship to come while negotiating the details of what has been only agreed in principle. Investors can afford to wait and see before concluding that Europe is solving its problems.