14 August 2012

Marco Annunziata: ECB - No free lunch

This column argues that the ECB is a lot stronger than many think. Linking ECB sovereign bond purchases to policy conditionality will ensure that reform efforts are sustained. The free lunch option has been ruled out – and that is a good thing.

The ECB expresses absolute confidence that the euro is here to stay. Therefore, it believes the fragmentation of financial markets has to be reversed, both because it impedes the functioning of monetary policy, and because it is based on the erroneous premise that the euro’s days are numbered. And reversing the fragmentation requires reducing the spreads.

However, the ECB also recognises that the market’s concerns on the sustainability of the euro start from very real economic problems in some member countries: poor competitiveness, weak fiscal positions, large external deficits. These cannot be addressed by monetary policy. In a context where many commentators and too many economists, on both sides of the Atlantic, argue that printing money is the solution to all problems, the ECB provides an anchor of common sense. ECB action makes sense only if governments do their part. And governments cannot be trusted to act without either pressure or commitment.

Therefore, ECB support will come only to countries that request EFSF help and sign up to the attached policy conditionality. Besides ensuring the sustainability of the effort, this link to conditionality should help allay the Bundesbank’s concerns on further ECB bond purchases. So should the decision to concentrate ECB purchases at the short end of the curve: this would keep them more within the realm of classic monetary policy, providing short-term respite to governments while they gain market confidence, rather than providing long-term financing of fiscal deficits. Draghi has repeated over and over that all ECB actions will be consistent with its mandate of keeping inflation low and stable. Finally, any bond purchases will be carried out with full transparency as to which bonds are being bought and in what amounts (unlike previous purchases under the Securities Market Programme), and Draghi hinted that the ECB would not seek senior creditor status, so as not to discourage private sector interest.

In the short term, markets will remain sceptical: ECB technical committees will now have to hammer out the details of an intervention strategy. To many investors, this will sound too much like the usual ‘euro-routine’: big words ('whatever it takes') followed by lengthy committee discussions rather than concrete actions.

The ECB’s commitment, however, should not be underestimated. Draghi stressed that his speech in London fully reflected the ECB’s view, and that the speech was “not misinterpreted” by the markets. In other words, the ECB promised it will do whatever it takes to keep the euro alive, and this will include intervening in government bond markets. And investors seem to realise that. Some commentators accused Draghi of having botched his communication strategy, promising a lot more in London than he could deliver in Frankfurt. But Draghi’s forceful London speech was not only necessary – as short-term sovereign yields were climbing fast – it was also effective: two weeks later, Spanish two-year yields were 150 basis points lower, Italian two-year yields close to 80 basis points lower. So much for the disappointment.

The ball is now in the governments’ court. The ECB’s message to Spain and Italy is clear: stop complaining about the spreads; if you want help, ask for it, and sign on to the policy conditionality that comes with it.

Full article

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