The recent rise in eurozone equities, along with a sharp further decline in peripheral bond spreads, has occurred in the face of continuing disappointing data on economic activity. Real GDP in the eurozone seems to be declining at a 2 per cent annualised rate in the current quarter, and the pivotal German economy is showing worrying signs of being dragged into the mire with the troubled south (see this earlier blog).
Markets are in one of those periods (which usually prove temporary) where they interpret bad economic news as being good news for asset prices, because weaker growth will result in easier policy from the central banks. In the eurozone, expectations are high that the European Central Bank will deliver lower interest rates on Thursday, and specific measures designed to address the provision of liquidity to small and medium sized enterprises (SMEs) in the south seem probable.
But a more radical easing in monetary conditions may prove necessary to drag the economy out of recession, and prevent inflation from falling further below the target, which is defined as “below but close to 2 per cent”. In March, the ECB staff forecast for inflation in 2014 was 0.6-2.0 per cent, which seems barely consistent with the mandate, especially as the recession shows no sign of ending and fiscal policy is still being tightened. Any other major central bank would be urgently reviewing its options for aggressive easing, and the markets could become very disillusioned if they sense that the ECB is unwilling to do the same.
So what, realistically, can the ECB do? The following table gives a fairly comprehensive list of the options which are definitely available within the mandate [A], those which might be available if the ECB chose to interpret its mandate more widely [B], and those which are clearly unavailable under any circumstances [C]:
The IMF on Tuesday repeated its call for the ECB to reduce policy rates in the eurozone, and Mario Draghi came fairly close to promising action in May at his press conference after the governing council meeting on April 4. But no-one really believes that the expected 0.25 percentage point cut in the main refinancing rate will do very much to solve the eurozone’s most pressing problem, which is the lack of bank lending to small and medium sized enterprises (SMEs) in the troubled economies.
Monetary conditions in the eurozone are fragmented. Bank lending rates are, perversely, much higher in the weakest economies than they are in the core. Unless this is solved, the eurozone economy will remain in trouble.
In order to address this issue, the ECB needs to think in ways which are unconventional, and therefore unpalatable for many of the conservatives on the governing council. However, both Mario Draghi and his colleague Benoît Cœuré have recently hinted that they view measures to eliminate fragmented lending rates as essential to fulfil the mandate of the ECB. This is how they justified the introduction of the Outright Monetary Transactions (OMT) programme, which saved the euro last autumn.
They have also said that the power of the ECB in this area is limited, and have argued repeatedly that effective action will require co-operation from member governments and from the European Investment Bank (EIB). It is therefore probable that discussions are under way between the ECB and member states to decide what can be done. There are two options which could have significant beneficial effects. Read more
The calmness of the financial markets in the face of the deteriorating Cyprus crisis in the past week has been remarkable. Although Cyprus is tiny enough to be completely overlooked in most circumstances, its economy and banking system have characteristics similar to other, much larger, eurozone countries. Cyprus is certainly at the extreme end, but an over-leveraged banking system, with insufficient capital and reliance on foreign funding, is familiar territory in the eurozone.
Cyprus is therefore, in some respects, a microcosm of the entire eurozone crisis, if a microcosm on steroids. The manner in which the crisis has been handled by the Eurogroup and the ECB will have demonstration effects on other economies, for good or ill.
At the time of writing, the outcome of this weekend’s negotiations remains uncertain. However, assuming that there is no catastrophic breakdown in the talks, leading to the exit of Cyprus from the euro area, the broad outline of the settlement seems to be taking shape. It is reported that the Cypriot government will accept a “bail in” of depositors in one or both of its troubled banks, allowing the release of eurozone financial support, while still keeping the government debt/GDP ratio under 150 per cent. Read more
When David Marsh wrote his definitive biography of the Bundesbank in 1993, he chose the following sub title: “The Bank That Rules Europe“. Feared and revered in equal measure, the Bundesbank was the model on which the ECB was built. Imitation was not, however, the sincerest form of flattery for Germany’s central bank. The arrival of the ECB removed most of its direct authority over monetary policy, leaving it with only one out of 23 votes on the governing council of the new central bank.
Recently, the Bundesbank’s President Jens Weidmann has been in a minority of one on the question of whether to launch the ECB’s new programme of Outright Monetary Transactions, to which he is fundamentally opposed. He views the proposed purchases of government debt in the troubled eurozone economies as a thinly disguised monetary bail-out of profligate governments, something which the Bundesbank had believed from the very beginning to be outside the intention of the treaties. Read more
Today’s decision from the German Constitutional Court in Karlsruhe is a major victory for Angela Merkel and for Germany’s preferred approach to handling the eurozone crisis. The court has approved the ratification of the ESM treaty, with only minor conditions attached.
It looks like a comprehensive defeat for those trying to mobilise political opinion inside Germany to block the treaty. As a result, the ESM and the fiscal compact can now be safely launched, and any immediate obstacle to Mario Draghi’s bond buying plan at the ECB has disappeared. What has emerged from this messy process is, in effect, an ESM leveraged by the ECB, something which seemed impossible this spring.
This represents a very large building block in the rescue strategy which the eurozone has gradually pieced together in the last three months.
The acute phase of the crisis peaked in mid June with the Greek election, which reduced the probability of a disorderly Greek exit.
Then, the eurozone summit in late June announced a roadmap for the long term reform of the eurozone. Mr Draghi was a co-author of the plan, and in retrospect it was a very important step, not least because he deemed it to be so.
These steps did not immediately settle the markets, and at times during July it seemed that the capital outflow from Spain would reach unmanageable proportions. However, at that point, Mr Draghi crucially said that the ECB considered it to be within its mandate to eliminate “convertibility risks” in the eurozone, and that statement basically turned the crisis around. Since then, for example, Spanish equities have risen by 30 per cent. Read more
The growth rate of the global economy is experiencing its weakest patch since the “upswing” in the cycle began in 2009. Of course, it has never been much of an “upswing”, given the depth of the recession which followed the financial crisis at the end of 2008. Still, the big picture seemed to suggest that global GDP was slowly on the mend, if not at a pace which could reduce global unemployment very rapidly. Now, even that modest recovery seems to be at risk.
Yesterday, we saw another leg of the policy response to this renewed slowdown. Monetary easing from the ECB, the Bank of China and the Bank of England followed earlier action by the Federal Reserve. As noted in this earlier blog, the central banks are back in play.
Markets have not been oblivious to this renewed round of easing: since the end of May, global equities have risen by 8 per cent and commodity prices have recently rebounded from their lows in spectacular fashion. Although ”shock and awe” from the central banks seems to have been replaced by a sense of rather tiresome routine, the impact of QE on market psychology has not entirely lost its traction.
That will only last, however, if the current global slowdown proves to be just another mid-year lull in a generally recovering world economy. So what are we to make of recent data? Read more
The weakness of global equities and other risk assets in recent weeks has clearly been driven by the deterioration in the eurozone crisis, but that has not been the only factor at work. There has also been concerted weakness in economic activity indicators in all the major economies, while the central banks have been sitting on their hands. That is never a good combination for asset returns.
This week, however, the markets’ hopes have been rising that the major central banks are once again preparing to ease monetary conditions, if not via a formally co-ordinated announcement, then in a series of separate steps which would amount to a powerful monetary boost to the global economy. Although this policy change may take a couple of months to transpire, it does indeed seem to be on the way. The pause in monetary easing which became clear in February/March has once again proved to be only temporary. Read more
Based on the latest opinion polls, the Greek election could result in a highly confused outcome, with the new government being unable or unwilling to meet any budgetary terms acceptable to the Troika, but also unwilling to leave the euro voluntarily. What would happen then?
Economists like Thomas Mayer (Deutsche Bank) and Huw Pill (Goldman Sachs) have recently argued that, in these circumstances, Greece might resort to a “parallel” currency which would be used for some domestic transactions, while keeping the euro in place for existing bank deposits and for foreign transactions. Thomas is favourably disposed to the idea, while Huw foresees many problems with it.
Although I am not at all convinced that this would be a stable solution, since it might just be a prelude to much higher inflation in Greece, it is the kind of fudged development which can appeal to politicians. It could therefore have a part to play in the future of the eurozone. Anyway, it is destined to be widely discussed in coming weeks. Read more
A few weeks ago, I wrote that the twists and turns in the eurozone crisis had, in the early months of 2012, lost the power to shock global asset prices. The reason given was that the prophylactic provided by the use of the ECB’s balance sheet essentially trumped the deteriorating economic fundamentals in several countries, notably in Spain. This view has since been severely challenged, but it has just about remained intact; after all, American and Asian equities are still 6-7 per cent up so far this year.
However, the crisis which surrounds political events in Greece threatens to change all that. This is the first major revolt by any electorate against the eurozone’s austerity policies, and it is those policies which have underpinned the willingness of the ECB to use its balance sheet to rescue the banking system. Furthermore, Greece is just the tip of the iceberg. The swing against austerity by voters in the eurozone is manifesting itself in many different places. I have been wondering whether this is good or bad news for the resolution of the crisis. Read more
Today’s governing council meeting at the ECB marked a return to “business as usual” after the dramatic injections of liquidity into the banking system in December and February. The ECB understandably wants to return to its regular duties, where it focuses on keeping inflation below its 2 per cent long term target, and is desperate to shift the burden for other aspects of managing the eurozone economy back to member governments.
Mario Draghi’s main message in recent weeks has been that “the ball is in the court of governments” in three different ways: the need for fiscal consolidation, bank recapitalisation and a “growth strategy” involving labour and product market reform. Assuming satisfactory progress on these three objectives, the ECB would retire to the relative obscurity of inflation control, a place where it is always happy to find itself. “Non standard” monetary measures, which involve the use of the ECB balance sheet to finance troubled banks and sovereigns, would no longer be needed.
Unfortunately, it is improbable that the ECB will be granted its wish to remain on the sidelines for very long. The key question is how, when and where it will be called back into action. Read more