With its decision of September 6 the European Central Bank has taken a large part of the “convertibility risk”, i.e. the risk of a break-up of the eurozone, off the table. Spreads have come down substantially in the following days, especially in Spain and Italy. Today’s decision by the German constitutional court to allow ratification of the bailout programmes should see those spreads come down further still.
The question now is whether countries will decide to activate the ECB’s intervention.
Requesting such programs entails costs and benefits.
The cost is mainly political, due to the stigma attached to any type of IMF or EU support. By asking for support, a government implicitly admits that its previous policies have not succeeded in convincing the markets. The negotiation of an adjustment program and the regular monitoring by the so-called troika (IMF-EU-ECB) is considered to entail a loss of sovereignty. Any government accepting intervention also fears losing political support. And the tougher the conditions attached to a programme, the higher the political cost associated with it.
The benefit consists mainly in the reduction of interest rates, especially at the low end of the yield curve, obtained by the ECB’s intervention, which reduces the cost of adjustment and alleviates tensions in financial markets. The lower the yield targeted by the ECB, the larger the benefit for the country to enter into a programme.
The reduction in interest rates that followed the ECB’s announcement may have temporarily reduced the incentives to request financial support. Furthermore, the assessment of the respective costs and benefits is still unclear. On the one hand, there are uncertainties about what the IMF or EU programmes will imply for the various countries, especially in terms of additional policy measures, although this will probably be clarified bilaterally over the coming days. On the other hand, the ECB has not – and will probably not – indicate any target for the level of Government bond yield it intends to achieve, making the benefit for governments uncertain.
Two scenarios may thus develop over the coming weeks and months.
A positive scenario would see financial markets continuing to react positively to the ECB’s announcement, achieving a permanently lower level of interest rates throughout the maturity curve. Under these conditions countries might not even need to apply to any program and the ECB’s threat for action would not have to be implemented.
However, in a negative scenario, the ECB’s announcement would have short lived effects as financial markets would not be convinced that countries can manage on their own. Rates would soon start rising again, amid renewed financial turbulence, forcing countries to apply to an IMF/EU program. The political costs of such a move would then be even higher, as countries would be perceived as being forced into a programme, rather than autonomously choosing to request one. The ECB would have to intervene, as indicated, starting however from a much higher level of interest rates and thus with much larger amounts.
The likelihood of the two scenarios depends on a series of factors.
The first is the reaction of governments and parliaments to the improved market conditions that have resulted from the ECB’s announcement. If national authorities take the opportunity of the renewed calm in financial markets for strengthening their reform programs aimed at increasing growth prospects, and adopt further measures, in particular privatisation, to accelerate the reduction of the debt, the likelihood of a positive scenario might increase .If instead the euphoria that followed the ECB’s announcement leads to a relaxation of the reform effort, or even to question some of the measures, the negative scenario would become more likely.
The second factor is the prospects for economic recovery in the various countries. Any unexpected cyclical improvement, which would contribute to ease the adjustment of the budget deficits and debts, could consolidate market confidence and make the virtuous scenario more likely. If, on the contrary, the general deterioration of economic conditions continues, with further downward revisions of growth prospects and upward revision of unemployment prospects, the risks of a negative outcome increase.
A related factor concerns the correlation between sovereign and banking risk. The improvement in government bond markets observed after the ECB’s announcement has been accompanied by a spectacular recovery in bank stocks. This suggests that the correlation is still strong. It may even increase if the process for bank restructuring and recapitalisation is delayed and if non-performing loans continue to rise as a result of a further slowdown of economic activity and weakness of the housing market. This could contribute to a worsening of the scenario.
The third factor is the development of monetary conditions in the eurozone, compared in particular to those in other major currency areas, which determine the external competitiveness of the euro. An improved competitiveness of the whole eurozone would contribute to support economic growth and tilt the balance towards the virtuous scenario.
A fourth factor is the management of pending critical eurozone issues, from the Greek adjustment program to the design of the longer term integration process, starting with the forthcoming discussion on the banking union. Negative developments in any of these areas could produce contagion effects that would push towards the negative scenario.
The balance between the two scenarios is not entirely in the hands of policy makers. But their actions can make a difference. We have already experienced in the past situation in which the improvements in market conditions, resulting for instance from the measures implemented by the ECB (for instance, last year’s 3-year LTRO), led to a relaxation of the adjustment process and a slowdown in the joint effort for improving the institutional framework supporting the euro. Restarting the effort again, once markets have deteriorated, proved each time to be much more difficult.
Regaining the confidence of the markets, once it has been lost, is extremely demanding. Regaining the confidence of the people is nearly impossible.