When Mario Draghi said on 26 July that a “convertibility risk” was preventing the smooth functioning of the ECB’s monetary policy across national borders inside the eurozone, he was breaking a taboo which has been stubbornly followed by all of his predecessors in the project to create a durable single currency. (See Alphaville here.) That taboo is that no-one in the ECB should ever admit that the euro might break apart. The objective of the taboo (which admittedly has previously been broken in the “special case” of Greece) has always been to ensure that markets should not feel the need to reflect any concerns about possible foreign exchange risk among the member states which comprise the euro.
By admitting that this “convertibility risk” now exists, the ECB president has implicitly acknowledged that the permanence of the single currency is not fully credible in the financial markets. The recognition of redenomination risk after a potential devaluation is one reason, he implies, why sovereign bond yields are now so high in Spain and Italy. He has said that this prevents the ECB from transmitting its intended monetary stance into those economies, which gives the ECB the right to take direct action to reduce these bond yields.
After last Thursday’s ECB meeting, it appears that this direct action will be to purchase short dated government bonds in Spain and Italy, provided that these governments have previously applied for support from the EFSF/ESM mechanism, and have accepted any conditions attached. The question is whether this action will be enough to put the convertibility genie back into the bottle. Read more